Reforming VAT and tax system: Challenges for developing countries

An amalgam of domestic and international pressures resulting from conditionality packages has fostered reform of tax systems across developing countries. From the 1980s until mid-1990s, developing country governments initiated a set of tax reforms that were substantially influenced by international financial institutions. Indeed, the International Monetary Fund (IMF), the World Bank (WB), and the Inter-American Development Bank (IADB) provided performance-conditional loans to fund tax reforms areas. The main goal of these reforms was to increase revenue while providing more stability in the targeted revenue systems. These measures have come at a price: considerations of burden shifting and tax equity have been omitted from the tax reform agenda. However, foreign influence on tax reform does not necessarily conflict with domestic approaches, since its main goal is to facilitate such reform. On the other hand, it is recognised that developing countries, once burdened with debt, had to meet the conditions set forth by the institutions offering access to capital.
The concept of crisis is a recurring theme in the literature. As a study said, a country's debt crisis and the resulting fiscal crisis make the offer of external resources powerful. It defined the circumstances in which countries approached international financial institutions. Because a crisis (most often hyperinflation) creates expectations of widespread economic decline, the probability becomes higher that leaders will begin-and voters will approve-bold reform processes, even at the cost of short-term losses.
Other observers of tax reforms in developing countries express similar judgments. These studies reason-from a breadth of country-experience-that major modifications to tax structure and administration are possible throughout a crisis. In the flux and urgency of crisis, the political opposition that commonly hinders significant change can be more easily overcome. This literature admits, however, that crisis is neither a necessary nor a sufficient condition to start reforms, given the influence of a range of other institutional and political elements, discussed below.
ELECTORAL SUPPORT: In the political economy literature on tax reform, politicians tend to be more often the focus of analysis than bureaucrats. One study, for example, seeks to explain tax policies as the final outcome of political transactions involving incumbent politicians. The rules of the political game under which politicians are elected and hold office will condition every policy. A median voter argument can be formulated as follows: as inequality increases, voters prefer higher taxes so long as these taxes are followed by state enacted redistribution. Redistribution would therefore result from voters forming a majority that presses for progressivity. Similarly, another study argued that once veto players and institutional constraints are accounted for, political optimality theories can provide a solid basis for addressing the political obstacles to reform.
Accordingly, a focus on the importance of political negotiation in the study of taxation has been spurred in part because the underlying technical works on taxation have not entirely grasped the reality of tax policymaking in many countries. In this vein, Profeta and Scabrosetti (2007) untangle the interactions between economic reforms and politics by recognising that reforms are often the central platforms for politicians to obtain votes. This is particularly germane in the case of taxation, where reforms appear to be a politically viable and favourable strategy to attain support. In actuality, mobilising support for tax reform is not easy, and redistributive reform presents even greater challenges. Furthermore, the electorate may be more interested in other issues, such as inflation or security, rather than prioritising tax policies, including burden-shifting tax reform. In this context, strong interests may be expected to attempt to block increasing taxable income and assets. In many instances, it seems that political pressures towards reforms eventually eschew any resulting net increase in tax burden targeting upper income groups.
PARTISAN ALLIANCES AND SUPPORT: It has been argued that the relative strength of political parties in parliament can have an effect on the approval of a tax reform, given the possibility of stalemates and conflicts in legislatures. According to this view, transition to democracy throughout Latin America with electoral rules such as proportional representation and multi-member districts have given rise to weak parties characterised by clientelism and personalism, and to party systems whose main attributes are fragmentation, polarisation, and volatility. These features, combined with presidentialism, have intensified the problems of deadlock between executive and legislature. The only feasible way for executives to get tax legislation passed would thus be to obtain support from legislative allies in exchange for spending programmes or tax incentives.
On the other hand, political parties are particularly relevant as the link between state and civil society, and they can provide support in the legislature needed to legitimate the government's tax measures. Empirical evidence from developed countries indicates that states run by left-wing parties tend to mobilise higher tax levels and adopt more progressive tax structures than those run by conservative, right-wing parties. Yet while it may be true that prudence is required when making broad comparisons between tax systems in developing and OECD countries, partisan alliances and cooperation within and across branches and levels of government in both regions are necessary if reforms are to remain effective. It was also ascertained that, at a political level, severe inequality can result when powerful groups minimise their relative tax burdens either by directing the policymaking process to the design of specific tax instruments, or by controlling tax administration so as to permit substantial tax evasion.
Similarly, it was argued that social inequality may lead to "elite groups" making every effort to introduce tax legislation that pushes a major portion of the fiscal burden onto lower income sectors. Can the opposition of these wealthy elites to reform in an unfair system be overcome? What kinds of political arrangements are likely to lead to socially optimal tax policy choices? The answers to these questions may explain why less-developed economies facing extreme inequality tend to have relatively regressive tax structures. As a starting point, the power of the business sector was explored which is exerted through organised associations or by individual firms and investors. In order to protect the interests of upper-income groups as well as corporations during the reform of the tax system, businesses are keen to engage in deliberate political action.
More generally, a bias in tax policymaking favouring business interests can be created through recruitment of business leaders into government, government-business coordination, and partisan linkages. Recruitment into government provides an opportunity for business leaders to take direct part in policymaking by occupying high-level executive branch positions. Cross-sector coordination in the form of regular government consultation and collaboration with a range of business associations can produce incentives to avoid conflict over taxation. Finally, partisan linkages can provide representation of business interests in Congress with veto power on taxation matters. Tax policy is thus shaped by powerful interest groups that lobby to keep the tax burden unevenly distributed. According to this perspective, political elites are often wealthy and are interested in keeping income taxes down for themselves and for middle classes, as a means to win their support in political competition. The more complex and less transparent a tax system, the easier it is for elites to engage in political lobbying. Further, policymakers would need to be immune to political interference in order to successfully carry out a tax reform, even if high-ranked tax officials were part of the political team of the incumbent government. The effects of corruption and campaign financing have also received attention in these analyses.
POLITICAL LEGITIMACY: The literature also raises the rather different (though related) issue of popular acceptance of a tax system. In the context of intense inequality, implementing more progressive taxes may be a more efficient strategy for promoting legitimacy of the tax system than adopting more neutral value-added taxes. Other works support this view. These argue that the incidence of taxes (i.e. where the tax burden falls) has an effect on both the distribution of income nationwide and the final configuration of public support for a full range of projects. Another, on the other hand, suggests that an uneven income distribution across a population in a country with powerful political groups excludes modern tax reforms that focus on the use of personal income or property taxes. Other studies highlight the distributional impact of public spending together with revenues when gauging the progressivity of a tax structure. These studies stress the effective role of public expenditure, rather than taxation, as a strategic governance tool for equity. In addition to public expenditure, transfers have also become a significant policy tool. It is argued that where redistribution is fairly large, it is for the most part attained through intergovernmental transfers rather than taxes. Therefore, the possibility of substantially improving tax redistribution rests mainly on raising the level of resources committed to transfers and refining their targeting, rather than attempting to improve the progressivity of the tax structure. A real decrease in social and political inequalities can only be accomplished by (i) introducing progressive tax systems, (ii) promoting equality of opportunities, and (iii) reducing discrimination.
 Developing countries face the basic challenge of raising revenue in a way that is not only equitable and economically efficient but that also enables the political survival of policymakers. Because politicians' political survival depends on their constituencies' support, it might be expected that political groups which are more successful in introducing pro-growth reforms remain in power longer, yet the opposite seems to be true. What pushes developing countries to reform their tax structure or tax administrations depends more on politics than the economics of taxation. That is, successful reform efforts depend on abilities such as arranging a coalition in support of the reform while hampering the rise of other coalitions that oppose it. There must be a politically viable way to move beyond the difficulties of reforming a tax system. Overall, it was found that politics determines to a large extent the capacity of these countries to design, approve, and implement effective public policies. Ideas and vested interests, therefore, as well as the political institutions, within which these elements interact, mould tax policy.
In summary, the current political economy literature on tax reform demonstrates that, in addition to domestic and international pressure, government approaches to tax policy have been in large part shaped by the following political elements: (i) Mobilising electoral support; (ii) The strength of political parties and coalitions in the legislature; (iii)  Elite control of tax policymaking or tax administration;  (iv) The degree of popular acceptance of tax policy; (v) Political survival that depends on a winning coalition of supporters. Thus, the political economy approach allows for an analysis that is broader than that traditionally deployed by strictly economic and technical approaches. However, a theory may be developed without considering its realistic implications, resulting in policy advice that makes sense in theory but may have negligible or even negative consequences in the real world - that is, these models may have clear "micro foundations" but their applicability to actual events is unknown or not obvious.
DEMOCRACY AND BUREAUCRACY: A significant portion of the literature shares the perspective that the taxation status quo is the result of governments attempting to take whatever they could, even in a non-democratic environment. There seem to be two different views on the matter. One view asserts that throughout much of Latin America, leaders who lack popular legitimacy have most tenaciously opposed tax reforms. Another says, there is little overall correlation between authoritarianism and tax reform, although there was a weak positive correlation between greater authoritarianism under certain circumstances, like Chile under Pinochet, with more success introducing comprehensive reforms. In non-democratic regimes, public officials often adopted an authoritarian stance, resorting to decree powers allowed under states of emergency as a means to overcome the national legislative body. Huber (2005) gives a similar explanation for the Argentine case, where large-scale modifications in the tax system (to increase indirect taxation) were accomplished during the military regime, and a series of follow-on measures have not resulted in significant popular protest. Overall, the widespread democratic transition in Latin America has not significantly reduced the regressive characteristics of the region's tax systems.
Neither has this transition eliminated the influence of political actors within the tax administration. It was pointed out that high-profile political leaders, top administration officials, and lawmakers enjoy ample discretionary powers where institutions are neither credible nor well functioning. In Paraguay, for instance, the persistence of widely diffused interests that sustains a clientelist, highly politicised public administration and promotes a system of political patronage. Potential improvements in tax efficiencies in Chile are more a political than an economic challenge. Important changes in public administrations may take place during times of crisis, when it is more likely that the political opposition and administrative inertia that typically block effective changes can be overcome. Finally, the success of a tax administration is tied more to the environment in which it operates rather than the capacity of administrative enforcement. Looking at the cases above, it can be concluded that a range of political constraints, coupled with conflicting interests in reform outcomes, have created hurdles that weak governments are unable to overcome, particularly: (i) Political patronage and clientelism; (ii) Executive-legislative deadlocks; (iii) Failure to win popular support for the reform;  (iv)The weakness of the state vis-à- vis upper income groups;  (v) Difficulties in overcoming coordination problems;  (vi) Policy-makers' ideological stance; (vii) Political influence within the tax administration.
Clearly, politics is a key variable that continues to influence tax reform in the developing countries. That said, it is worth noting that some relevant changes are gradually occurring and tax systems of the last decade are different to an important degree from those of the 1980s.
(The second part of the article will be published on Saturday, June 17, 2015).

The writer, who holds PhD and FCA, is General Secretary, Bangladesh Economic Association and Chairman, Emerging Credit Rating Limited.
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