As discussed in the January 2015 edition of Global Economic Prospects, raising more in tax revenues is critical for the South Asia region. Firstly, fiscal buffers have diminished since the 2008/09 global financial crisis. Although efforts to consolidate are underway, evident for example in the recent fuel subsidy reforms in India, replenishing buffers will also require raising more in revenue. Secondly, given low tax ratios and debt levels over 60 percent of GDP in some countries (India, Pakistan and Sri Lanka), long-term fiscal sustainability hinges upon better revenue mobilization.
Even more importantly, a larger tax revenue envelope would help fund critical spending on infrastructure and social needs. South Asia is home to just under 40 percent of the world’s population living under the $1.25 per day (PPP) poverty line. And, poor infrastructure is a constraint on growth. Infrastructure spending needs are estimated at US$1.7 to 2.5 trillion (at current prices, cumulative up till 2020). Part of the funding for this will have to come from governments through higher tax revenue mobilization.
As Figure 1 shows, all governments in the region collect less in taxes as a share of GDP than the median middle-income country. Despite ongoing tax reforms, the larger SAR countries have struggled to increase their tax-to-GDP ratios over the last decade despite ongoing tax reform. Moreover as research shows (Gupta, 2015) the region lags not just in the mobilization of total tax revenue, but also of different types of tax revenues.
Why are tax revenues so low?
Tax collection has been held back for several, interrelated reasons (Gupta, 2015):
A narrow tax base. Tax payments tend to be concentrated only among a few taxpayers in South Asia. In India only 3 percent of the population pays the personal income tax, with the figure even lower at about 1 percent in Bangladesh, Nepal, and Pakistan. A plethora of exemptions also exist, which have made tax systems more complex and may have contributed to the emergence of vested interests to resist further reforms.
Inefficient tax administrations. SAR countries typically rank low on the common yardsticks of efficient tax administration. For instance, time spent preparing and paying taxes for a typical firm in South Asia is more than 300 hours, compared to 200 hours in East Asia and 175 hours in advanced countries.
Structural factors. Previous research has shown that higher shares of agriculture and service sectors in GDP are negatively correlated with revenue to GDP ratios in developing countries, as is poor governance. This is particularly relevant for larger South Asian countries, where agriculture has historically been under-taxed, while service sectors are also relatively large. Other factors that may impinge on low revenue mobilization include low literacy rates, large rural populations, large informal economies, and poor governance. In addition, the financial sector is underdeveloped in SAR countries with the implication that financial transactions occur in cash, abetting tax evasion. Indeed countries that have succeeded in increasing the size of their financial sector in the past decade (Bhutan, Maldives, and Nepal) have also managed to increase their tax ratios.
So what are some of the reform priorities?
South Asia needs a second generation of tax reforms, with efforts focused on the following:
Broadening the tax base and simplifying tax structures. Policy makers need to review extensive tax exemptions and widely employed tax holidays. Tax coverage should also be increased to sectors that are currently undertaxed. More generally, tax policy should refrain from attempting to achieve multiple objectives such as the development of regions or industries, infrastructure creation or choice of technology as it complicates the tax system, increases compliance cost (and potentially the degree of informality), and distorts economic choices.
Strengthening tax administration and improving compliance. The institutional arrangements and organizations for tax administration should be granted more political independence, insulated from political influences, and provided adequate resources to enhance data collection and assessment capacity. There has been limited progress in moving to e-tax administration, likely reflecting low literacy and e-literacy, and lack of financial and technical resources. In addition, there is a challenge of ensuring that “hard-to-tax” professionals (e.g. doctors, lawyers, architects) are within the tax net.
Country specific priorities. Besides these common challenges for SAR countries, there are country-specific challenges. For Nepal, the sequencing of tax reforms will matter, with small initial changes in specific tax laws likely to yield relatively large improvements in tax revenues. Pakistan is already implementing comprehensive and multipronged reforms spanning tax administration, regulatory reforms, and governance reforms. In light of fiscal decentralization reforms in recent years, the tax administration capacity in the provinces needs to be strengthened to ease financing constraints.
Most countries in the region would also likely benefit from considering a bigger role for the value-added tax (VAT). Bangladesh is currently undertaking reforms to strengthen tax legislation and administration, but the implementation of a new value-added tax regime which would replace an existing non-uniform goods and services tax (GST), a critical element of tax reforms has been repeatedly delayed in the face of considerable public opposition. Finally, in India, the existing GST is fragmented with rates and administration varying by state. A new GST was announced in 2008, but has missed several implementation deadlines although there are signs of progress under the newly elected government. In particular, a constitutional amendment bill for introducing a uniform GST was tabled in the lower house of the Parliament in December 2014. If implemented, as expected in 2015, it is likely to boost revenues by reducing distortions and creating a single market for goods and services. In Bhutan, where revenues depend to a large extent on hydropower, revenue sources must be diversified for stable and increased revenue generation. Similarly, in Maldives, tax collection relies on tourism, and for sustainable tax collection, revenue sources must be diversified.
In summary, tax reforms, done right, will put public finances on a more solid footing and provide space needed to counter adverse shocks to growth. Over the longer term, by raising the amount available to spend on education, health and other public services including infrastructure, they may help raise potential growth in the region.
Figure 1. Total Tax Revenues
Source: World Bank calculations using data from the World Development Indicators, Government Financial Statistics and IMF Country Reports.
This article is published in collaboration with The World Bank’s Prospects for Development Blog. Publication does not imply endorsement of views by the World Economic Forum.
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Author: Tehmina Shaukat Khan contributes to the World Bank’s annual flagship publication, Global Economic Prospects, as the main author of the global outlook.
Image: A man looks at a stock quotation board outside a brokerage in Tokyo May 11, 2012. REUTERS/Toru Hanai