FILE PHOTO: Kenyan police officers detain a Kenyan social-political activist during a protest to call on lawmakers to reject the finance bill proposed by the government that would raise various taxes, outside the Parliament Buildings in Nairobi, Kenya June 13, 2023. REUTERS/Monicah Mwangi/File Photo

Can we tax ourselves out of debt into development? A perspective

From a development perspective, taxes are not only a source of revenue; a more comprehensive analytical framework considers four main purposes of taxation. The first purpose, revenue generation, is also an instrument of macroeconomic policy. A second purpose is redistribution, through progressive taxation and limiting tax incidence on people with lower ability to pay. Redistribution is important because development has increasingly become an issue of inequality, also at the national level. A third purpose is representation; taxation is a catalyst for the establishment of governments that are more responsive and accountable toward their own citizens. Development aid has no such effect and fosters accountability to external donors instead. A fourth purpose of taxation is repricing, which refers to minimizing market distortions and providing tax incentives to address externalities. Different types of taxes have different properties. Taxes on personal and corporate income tend to have the strongest positive effect on governance but provide a relatively strong disincentive to economic activity.[1]

Developing countries need to replace foreign grants and loans with domestic tax revenues because the former is not a reliable long-term source of development financing. Moreover, many developing countries have made considerable progress in reducing poverty over the past few decades and have experienced strong economic growth. As countries become less poor, they become less eligible for aid. By 2012, 49 countries were classified as LDCs. Poverty in these countries is widespread and severe, they have a low level of economic development and are vulnerable to external shocks. Currently, most poor people live in lower-middle income countries, examples are India, China, Nigeria, Indonesia and Pakistan, these countries have a huge junk of the population of the world, close to half of the world population. For these countries, development has increasingly become an issue of inequality, not just in the international space, but also and mainly at the national level. Accordingly, development financing is shifting from external aid to domestic resource mobilization.

However, there exist other and more pervasive reasons why developing countries should reduce dependency on foreign aid and increase domestic tax revenues. Tax and aid have very different qualities and therefore different impacts on economic growth and institutions. First, aid flows are often more volatile and unpredictable. The erratic behavior of aid flows limits their potential positive impact.[2] Second, aid may result in rent-seeking behavior by political elites.[3] Third, development aid fosters accountability to external donors but limits pressure on governments to legitimate their actions to the population.[4] By contrast taxation, is a catalyst for the establishment of governments that are more responsive and accountable towards their own citizens.[5] Fourth, bilateral and multilateral aid usually involves aid conditionality. To some extent, a conditionality has shifted from policy conditions to institutional reforms that have a broader and more permanent positive effect on development.[6] However, in many cases aid conditionality still limits macroeconomic policy options for developing countries and this may hinder sound Development policies.[7] Fifth, some aid is diverted directly or indirectly to finance capital flight.[8] Although this may also apply to government revenues from oil and other natural resources, transparent tax revenues do not produce this adverse effect. These five reasons make tax revenues a key component of finance for development.

Policy challenges in developing countries

There are several challenges in raising corporate tax revenues in developing countries. There are international constraints and domestic constraints. These include weak administrative capacity.[9] Understaffed and poorly funded tax authorities limit both the amount of corporate taxpayers that can be assessed and the quality of assessment. Hence many small taxpayers are not taxed at all, and large taxpayers may relatively and easily reduce their burden using international tax planning strategies without being challenged by tax authorities.

Most developing countries also have a large shadow economy. Cobham (2005a) estimates that tax revenues in developing countries could increase by USD  110 billion per year if shadow economies were brought into the formal system to the extent feasible. The large size of shadow economy does not only result from administrative constraints but also depends directly on the tax culture and institutions of a country.[10] Government performance influences the tax culture as well. Strong and progressive tax regimes and equitable access to public goods and services strengthen the social contract and contribute to a more positive attitude towards taxation.[11]

Another problem, related to globalization, is the loss of revenues due to tax competition and tax incentives granted to foreign investors.[12] These tax incentives can take many forms, including tax holidays, exemptions from various types of taxes, accelerated depreciation of investments and tax credits.[13] It is often thought that foreign investment is highly responsive to tax. Various econometric studies confirm this and suggest that export-oriented investments are especially sensitive.[14] The apparent effect of taxes on the location decisions of multinational firms has been a reason for lowering tax rates and granting exemptions. This has resulted in tax competition among developing countries, to attract FDI.[15] In the end, this is detrimental to all countries involved, because lowering taxes across a group of countries hardly changes their relative attractiveness for foreign investors. Developing countries are therefore generally advised to limit the use of tax incentives to specific cases of market failures and focus on improving the overall business environment.[16]

Tax avoidance due to trade mispricing is also a major constraint to revenue mobilization. When affiliates that belong to the same multinational trade with each other, they set internal transfer prices. The current international standards for transfer pricing, developed by OECD, specify that the trade should be at an arm’s length, that is, prices should not differ from those charged to unrelated parties. However, it’s easy to manipulate, because for many trades there are no comparable transactions with unrelated parties.

Policy coherence for development

The concept of PCD can refer to the absence of policy effects contrary to the sins of development policy as well as to the creation of synergies between different government departments to achieve development objectives.[17] PCD means working to ensure that the objectives of a government’s development policy are not underestimated by other policies of that government, which impact on developing countries and that these policies support development objectives where feasible.[18]

Apart from incoherence within development and other external policies, PCD has been extended to cover the effects of other policy areas as well.[19] Trade policy by far much the most widely included in PCD initiatives.[20] OECD( Organization for Economic Co-operation and development) has six key policy areas that include foreign investment and mentions that OECD efforts to tackle tax evasion contribute PCD and that double taxation can be a serious barrier to trade and investment.[21] Still tax issues are rarely included in PCD initiatives of donor countries.

The Coherence between corporate taxation and development policies, including decisions on the location of real business activities as well as on the location of profits within a multinational. A recent example in Kenya that has elicited sharp mixed reactions from different quarters is the China Square mall that’s selling items cheaply.

In conclusion, developing countries need sustainable sources of finance for public expenditures and investments. Before heading out for international funding, they ought to enhance domestic revenue mobilization.  In developing countries, corporate taxes are an important revenue component. This means that potential threats to corporate taxes such as tax avoidance by multinationals are highly relevant in the context of financing for development.

The author is a final-year student at the University of Nairobi Faculty of Law.

[1] Francis Weyzig, Taxation and development; Effects of Dutch policy on taxation of multinationals in developing countries (page 7)

[2] Bulir and Hamann, 2006; Lensink & Morrissey, 2000; Weeks, 2010.

[3] Djankov et Al., 2008.

[4] Moss et Al., 2006.

[5] OECD, 2010

[6] Adam & O’Connell, 1999.

[7] Weeks 2010

[8] Serieux, 2011

[9] IMF,2011

[10] Torgler and Schneider, 2007.

[11] OECD 2008a

[12] CABRI et Al., 2010.

[13] For a more detailed discussion on different types of tax incentives, see Tanzi and Zee(2000)

[14]  Grubert & Mutti,2000,2004, Hines, 2005.

[15] Klemm & Van parys, 2012; Nassar,2009.

[16] CABRI et Al.,2010; James, 2009; Zee et Al., 2002.

[17] Hoebink, 2004; OECD, 2001.

[18] McLean Hilker, 2004, p.5

[19] Hoebink,2005

[20] European commission, 2007a.

[21] OECD, 2005.

Guest author The Platform Magazine