Developing nations can foster economic growth by investing in infrastructure. Roads, bridges, and airports make it easier to transport people and goods—the best product in the world has no value if you cannot get it into customers’ hands when they need it. Thus, public spending for infrastructure is critical to improving the standard of living for billions of people. Yet, there is a major barrier holding back such spending.
Poor Tax Administration.
Public spending is only possible if the government can first collect tax dollars, and developing nations have difficulty generating tax revenue. One study notes that, “poorer countries collect on average only two-thirds or less of the amount of tax revenue that richer countries do, as a fraction of GDP.”1 Insufficient tax revenue makes it difficult to fund public projects. International aid can provide capital, but if the government is unable to draw on a consistent source of tax revenue it will struggle to make and maintain public improvements. Countries endowed with rich deposits of oil are an exception and needn’t rely heavily on taxes, but natural resource dependence creates its own set of issues. For most countries, the ability to raise taxes is a necessary condition for investing in infrastructure.
But tax administration isn’t exactly an exciting topic of discussion.
For some people, tax administration is the only topic more boring than taxation itself; as a form of entertainment, it barely outranks staring at a blank wall and being forced to watch every episode of Keeping Up With The Kardashians.
Yet, the improvement of tax systems should not be ignored; taxes provide the stable source of revenue needed to fund public projects and unlock economic growth. Improving tax systems is easier said than done, however. Many developing nations lack the information technology required to track and process financial data. In many countries, tax collectors do not have access to the financial data and record-keeping systems that are taken for granted in developed nations. The lack of formal record-keeping leads to a second problem.
Given the lack of transparency and records, tax collectors in developing nations have a tremendous amount of leeway when it comes to assessing and collecting taxes. They often turn this to their advantage by requesting bribes in exchange for more favorable tax assessments2 (think of it as tipping a barista for remembering your favorite drink). When they succeed in obtaining a bribe, the tax collectors benefit—as do the taxpayers who see their tax bill reduced. Society as whole, however, loses. Roads, sewer systems, and water treatment facilities are not constructed, and those at the bottom end of the economic spectrum are hit hardest.
Given these facts, how can developing nations generate more tax revenue?
One way is to bribe the tax collectors to take less bribes. It is the type of strategy that initially sounds ridiculous but makes more sense over time. Think of it as a principal-agent problem: the government (the principal) has delegated the responsibility of collecting taxes to the tax collector (the agent). But the principal and agent have different objectives—the government wants to maximize the efficiency of its tax collections (if $100 of taxes are owed, it wants to collect all $100) while the tax collector wants to maximize his or her utility (by obtaining as much money as possible, through bribes, salary, etc.). The government and the tax collector have different incentives, and this causes the tax collector to engage in behavior (seeking bribes) that is harmful to the government (by reducing its tax revenue).
The government may be able to solve this problem by offering the tax collector a piece of the action. This is the same logic behind the increased use of stock options as a form of executive compensation. Want your CEO to care more about the value of the company’s shares? Give the CEO some skin in the game. Governments can give tax collectors an incentive to collect more taxes by allowing them to keep a percentage of the taxes they keep.
A study of property tax collectors in Pakistan found that the pay scheme that raised the greatest tax revenue was one that paid tax collectors 30% of whatever taxes they were able to collect.3 In the study, tax collectors from the province of Punjab were assigned to one of four pay schemes:
1. Revenue Scheme (tax collectors receive 30% of revenues collected)
2. Revenue Plus Scheme (tax collectors receives a bonus partly-based on revenues collected and partly-based on taxpayer satisfaction and accuracy of the assessment)
3. Flexible Bonus Scheme (tax collectors receive a bonus based on a subjective assessment of several criteria by the tax department)
4. Control Group
Each of the pay-for-performance schemes increased tax revenue relative to the control group, with an average revenue growth of 46% across the three schemes. The Revenue Scheme was the most effective with a 57% increase; interestingly, it was not dramatically different from the other schemes in terms of taxpayer satisfaction either. In other words, tax collectors who were given a portion of the proceeds brought in more taxes, but they didn’t have to rough up the taxpayers to do so.
But there’s a catch.
The increased tax revenue came from increased assessments of a small number of taxpayers’ homes. For most taxpayers, the tax assessment and the tax paid did not change. This means that most taxpayers continued paying the same amount of tax while a few taxpayers paid a lot more tax.
Apparently, the pay-for-performance idea worked too well. Taxpayers, given a proper incentive to collect tax, zealously did their duty—unless the taxpayer was willing to offer a gratuity. This had gone on before, but now the tax collectors wanted a much larger bribe because they had more bargaining power: if you don’t pay the bribe, the tax collector can simply enforce the tax and profit from the proceeds. The tax collectors’ incentive to collect the tax had become stronger, so they demanded a higher bribe to look the other way.
Many taxpayers paid the increased bribe, but some said they’d rather pay the tax than a higher bribe. And for this reason the government received more tax revenue than it would have without a pay-for-performance scheme. From a public finance perspective, the new pay scheme was a success.
Pay-for-performance tax collection (commonly known as “tax farming”) is not a new idea. In most countries it has fallen out of favor—possibly because people are concerned about tax collectors using their authority to collect more tax than what is due.4 But inefficient tax systems have renewed interest in tax farming. Pakistan is not the only country that has begun to experiment with pay-for-performance schemes.5
But improving the standard of living for developing nations will not be accomplished solely by reforming tax systems. Some countries face a number of impediments to economic growth: they are landlocked with bad neighbors, they experience frequent revolutions, and property rights are poorly enforced.6 All these issues must be addressed. But without the ability to collect taxes, most governments will be unable to fund the infrastructure development that is needed to spur growth. Thus, efficient tax systems are a necessary but not a sufficient condition for success.
1. Gordon, R., & Li, W. Li. (2009). Tax structures in developing countries: Many puzzles and a possible explanation. Journal of Public Economics, 93(7-8), 855–866.
2. Olken, B. A., & Pande, R. (2012). Corruption in developing countries. Annual Review of Economics, 4, 479-509.
3. Khan, A. Q., Khawaja, A. I., & Olken, B. A. (2016). Tax farming redux: Experimental evidence on performance pay for tax collectors. Quarterly Journal of Economics, 131(1), 219-271.
4. Olken, B. A., & Pande, R. (2012). Corruption in developing countries. Annual Review of Economics, 4, 479-509.
5. Kahn, C. M., Silva, E. C., & Ziliak, J. P. (2001). Performance-based wages in tax collection: The Brazilian tax collection reform and its effects. Economic Journal, 111, 188–205.
6. Collier, P. (2007). The bottom billion: Why the poorest countries are failing and what can be done about it. New York, NY: Oxford University Press.
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