Taxation in a Low-Income Economy

Channing Arndt, Finn Tarp

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781134018932
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This volume contains a stimulating collection of analytical studies focusing on taxation in Mozambique. It tells a compelling story about tax systems in a low income economy increasingly integrated into the world trading system, but very much dependent on foreign trade taxes and international development assistance.

Key issues covered include:

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• A better understanding of the historical background of tax reforms in a representative African economy (Mozambique) along with an assessment of taxation performance in a comparative perspective.

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• Insights into the practice and implications of tax policy, both from the perspective of the consumer and the firm level.

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• Discussion of the existing institutional set up in which tax policy and its enforcement operate and analyses of current tax practices.

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• Taxation themes at the border and at domestic level, which are typical for low-income economies, characterized by a high degree of reliance on foreign trade taxes.

This volume is meant as a guide for developing country government officials and professional aid practitioners as well as academics, researchers and tax policy analysts working in the development field. It will also be of interest to students of development with a special interest in public finance issues in poor countries and how to improve policy-effectiveness, including tax policy, in a developing country setting.

1 Introduction and overview

Channing Arndt, Sam Jones, Finn Tarp and João E. Van Dunem

1 Tax policy matters for development

Tax policy in less-developed countries merits utmost interest. As governments seek to mobilize requisite resources to finance basic public expenditures and promote economic and social development, the ability to design effective tax systems becomes indispensable. Effectiveness, in conjunction with efficiency and equity, is perceived as a desirable criterion. But fulfilling these goals is far from easy. Many trade-offs are inherent and critical, and in most developing countries tax policy options are invariably constrained by the structure of the economy and administrative capacity. Wealthier taxpayers are likely to try to avert tax reforms seen as prejudicial to them. On top of this, tax systems in developing countries are often unduly complicated, attempting to meet too many objectives, let alone riddled with exceptions and hence often beyond the capabilities of tax authorities to administer. All combined, these factors pose a potentially serious risk to the government’s capacity to broaden the tax base and, ultimately, generate much-needed revenue.

A rather different reason why tax policy in less-developed economies deserves consideration concerns the pursuit of macroeconomic stabilization. Unless reasonably stable macroeconomic conditions are put in place, developing countries will have a hard time finding their way onto a path of sustained economic progress. In recent times, many of these countries have been confronted with growing fiscal deficits, as a corollary of unexpected negative external shocks blended with over-ambitious development programmes. In the face of rising debt burdens, declining commodity prices and ever-increasing trade imbalances, commitment to fiscal austerity appeared as a fundamental priority of macroeconomic policy. Sadly, in a very large number of cases, fiscal retrenchment to obtain budgetary balance entailed substantial cuts in government expenditure, often with adversely severe implications for social services offered to a vulnerable segment of the population. Strengthening tax systems can help not only to reduce the savings gap but also to alleviate the inherent costs of the adjustment process in developing countries.

Pursuing macro-stability is meant to create a more predictable basis for making decisions. It would be a mistake, nonetheless, to overlook the fact that in most developing countries the scope for economic stabilization via monetary and exchange rate policies is severely hampered by local circumstances. Well-organized and locally controlled money markets are frequently lacking, thus constraining the ability of governments to control monetary policy instruments. To give just one example, many financial institutions in less-developed countries happen to be simply overseas branches of private banks in developed countries. In addition, one must be mindful of exacerbating problems of currency substitution (cases where the local currency can be replaced by a foreign currency), openness of the economy (e.g. pegging of local currency against a foreign one) and an absence of transparency in credit markets with regard to, say, the disclosure of the quality of loan portfolios. The joint contribution of these aspects circumscribes the use of monetary and exchange rate policies, while making fiscal policy a very appealing and unique developmental policy instrument.

Tax policy in less-developed countries has also, in a large number of cases, incorporated fiscal concessions and incentives to attract foreign investment. Most governments in those countries tend to offer all sorts of favourable terms to foreign enterprises (very often large transnational corporations), including long periods of tax exemption, generous investment depreciation allowances, special tax write-offs, tax credits and so forth. Under such circumstances, the capacity of governments to collect revenue from these large foreign enterprises is thwarted. Given some discomfort about its real benefits, it is hardly surprising that the use of this particular policy has in some ways produced an ongoing controversial debate concerning the desirability of special tax treatments for foreign firms. When dealing with poor countries, accordingly, there is very little doubt that the formulation of a sound tax policy can make a huge difference in several important respects. It is intimately connected to their macroeconomic setting and so can be a powerful tool to influence their economic development.

2 Rationale for a tailored tax policy: the case of Mozambique

Mozambique is one of the poorest and most aid-dependent countries in the world. In 2004, this Sub-Saharan African country located in the south eastern part of the continent achieved an overall ranking of tenth from bottom in the Human Development Index (HDI), marginally outperformed by the conflict-afflicted Democratic Republic of Congo. Incidentally, none of its neighbours, including Zimbabwe, finished the year with a lower human development rank (UNDP 2006). Despite some recent progress, official estimates of poverty are high. On the basis of a 2002–3 national household survey, indicators suggest that 54.1 per cent of the population is not able to satisfy basic physical needs (including food, clothing and shelter).¹ Meanwhile, if we merely restrict our attention to the rural areas, where approximately 70 per cent of the population live, the picture becomes gloomier, with 55.3 per cent of the population believed to live below the poverty line.

The challenge to provide essential social services, primarily to the poor, is tremendous. Most basic social services, such as health care and education, are paid out of public funds. The country is currently highly dependent on foreign aid inflows, with approximately half of the national state budget being financed externally by means of grants and concession loans. To overcome both underdevelopment and dependency, a clear definition of long-term and interim objectives of various policies to be framed, including tax policy, is of critical importance. To be sure, reconciling the objectives of stabilization with high levels of public spending on essential services will require a strengthened effort from taxation in the coming decade. Also, local circumstances tell us that, to a considerable extent, the policy constraints discussed in the preceding section are prominent. For these reasons, tax policy in Mozambique must be viewed as a way to ease those constraints and enhance the government capacity to both finance the expansion of social services and redress internal and external imbalances.

Mozambique is not exempt from the tax policy challenges seen previously. These are standard among less-developed economies. But, like any low-income country, it too has special characteristics. It varies from other poor countries in several features such as size, history, natural resource endowments and even in the exact economic structure or capacity to administer taxes. Given the idiosyncratic nature and complexity of the economic and political environment, the tax policy space will tend to be dictated with a view to integrating country-specific circumstances. In more general terms, thus, it may well be the case that actual tax systems in low-income economies find themselves systematically disconnected from guides emerging from optimal taxation theory. In the absence of a clear-cut prescription from optimal taxation theory, country-specific studies turn out to be indispensable. They can serve the purpose of providing practical answers to questions where taxation theory cannot provide definitive advice. This book was put together with this intention in mind.

With tax data becoming more and more accessible, the formulation of the best feasible tax policy can benefit from in-depth country approaches that are able to evaluate taxation choices and the potential impact of changes to the statutory tax system. Headway in accessibility to reliable data has been made in Mozambique over the last few years and this development has made possible the variety of studies available in this book. The book contains four core parts. Part I begins by providing a better understanding of the historical background of tax reforms in Mozambique and offers insights into the practice and implications of tax policy, at the level of both the consumer and the enterprise. Part I also takes seriously the issue of taxation performance in Mozambique from a comparative perspective, attempting to draw some lessons from the taxation effort on the basis of international evidence. In Part II, selected issues related to the institutional set-up where tax policy operates are brought to the forefront. Finally, Parts III and IV address selective taxation themes at the border and at the internal level, respectively, and we document in the Annex an up-to-date Social Accounting Matrix (SAM) dataset for Mozambique.

3 Background and context

The first step in the analysis of tax policy in Mozambique is to provide a retrospective overview of the successive rounds of tax reform. Chapter 2 (Byiers) takes a brief look at the principal tax reforms in Mozambique since independence in 1975. It gives a preliminary analysis by drawing lessons from the tax reform experience and revenue behaviour over the past 30 years or so. In particular, Byiers considers the fiscal impact of recent tax reforms and arrives at the conclusion that those were insufficient by themselves to encourage sustained increases in public revenue, in spite of sporadic gains over time in revenue-to-GDP ratios.

As noted earlier, the principle of equity is traditionally viewed as a central criterion when attempting to design or evaluate tax systems. In developing countries, actual tax systems are often far from progressive. This necessarily motivates a reasonable amount of concern and demands appropriate consideration on a country-by-country basis. The purpose of Chapter 3 (Sonne-Schmidt) is to explicitly address incidence analysis in the Mozambican context. By making use of a countrywide household survey, the author employs a standard non-behavioural tax incidence methodology to investigate the progressivity of taxes. The author is able to demonstrate that there is scope in Mozambique for the tax system to be reformed in ways that would improve the welfare of poor households.

Household survey evidence is complemented, in Chapter 4 (Byiers), by a formal assessment of the application of tax policy and its impact at the firm level. Based on manufacturing enterprise survey evidence from 2002 and 2006, Byiers reports an inverted-U relationship between the size of a firm and its tax ratio, with firms at opposite ends of the firm-size spectrum experiencing a relatively low tax burden when compared to the ones located in the middle. What the analysis shows is that there is both revenue concentration and marked administrative pressure on mid-size firms, which also creates room for possible disincentive effects for firm growth. At the origin of this is tax policy action. This study is able to identify, nonetheless, other factors deemed important in explaining firm tax ratios. The empirical findings show, finally, that bribery and corruption play a more significant role than firm-size in explaining the practice of under-declaration of sales.

From policy at a micro level, the analysis evolves in Chapter 5 (Jones) with an evaluation of a cross-cutting issue. Standard optimal tax theory has very little to say with respect to the ideal overall tax level for an economy. So, Part I ends with an appraisal of the aggregate performance of the Mozambican tax system, judged against the international experiences of other developing countries. It is widely established that the taxation potential of a country depends, to a large extent, on factors like the income-per-capita level, the social, political and institutional setting, the importance of various types of economic activity and the industrial structure of the economy. The study in Chapter 5 builds upon an approach widely used in the 1960s and 1970s to establish the appropriateness of aggregate tax levels.² Specifically, Jones develops a cross-country panel dataset to investigate the hypothesis that taxation receipts in developing countries are constrained by relatively slow-moving institutional and structural factors. In line with previous scholarship, the author shows empirically the importance of these constraints for the volume of tax revenue governments are able to raise. Calibrated with Mozambican data, the model suggests that Mozambican taxation performance has not deviated significantly from its predicted levels.

4 Institutional framework and current practices

Against this background, Part II considers the institutional setting in which tax policy and its implementation take place. Tax administrations in developing countries are notoriously weak. Chapter 6 (McCoy and Van Dunem) discusses the institutional design of the tax-gathering branches of government and its ongoing transformation process. For reasons that mainly lie with their individual stage of reform process, there is an obvious need to proceed analytically, making a clear distinction between the customs authority (Alfândegas), being the department responsible for the collection of border taxes, and the department administrating internal taxes. At a time when a semi-autonomous revenue authority is being made fully operational, the authors present key insights with regard to fiscal administration, by using the 10-year-long experience with reform in customs as their basis of assessment. The chapter underscores the fundamental role of factors such as the political commitment and the institutional setting (notably in the area of internal incentives), if efficiency gains are ever to materialize.

The subsequent chapter, Chapter 7 (Orlowski), focuses on the current institutional relationship between donors and the Mozambican government in the sphere of donor-funded projects and their resulting fiscal obligations. There is a pattern in many low-income economies in which payment of indirect taxes resulting from donor-funded public works is guaranteed by the recipient governments, since most donors decline the payment imposed under normal conditions. Orlowski addresses this question, certainly of great relevance within the Mozambican context. Usually, to avoid the introduction of further exemptions, governments pay the tax levies from their own domestic resources. In principle, from the fiscal point of view, the adoption of this type of practice should be equivalent to the outcome with exemptions in place. The chapter shows that this model of government as taxpayer on one side and tax collector on the other leads, in practice, to under-budgeting of tax votes and growing arrears with contractors. Beyond diagnosis of the dilemma, the chapter proposes a solution that opens the way for donors to reconsider their ‘no tax’ rule.

Chapter 8 (Jones and Paulo) takes a detailed look at the fiscal modelling tools used in Mozambique. It argues that while there is substantial theoretical debate regarding different approaches, there is little concrete guidance for the policy-maker in low-income countries. As a result, the chapter presents a general evaluation framework for macro-fiscal models which is then applied to the specific case of interest. The authors document that the model used in Mozambique—essentially a financial programming tool with additional budgetary detail—has seen considerable improvements over recent years. Even so, one of the more fundamental challenges regards the management of the model and its effective input into policy-making. A broad conclusion is that the character and adequacy of quantitative models reflect deeper political economy influences on the management of macroeconomic and fiscal policy. Over the short to medium term there is scope for reasonable enhancements to the modelling approach, incorporating further attention to the behaviour of major tax lines.

The search for improved revenue forecasts is certainly an important element of the institutional framework. In Mozambique, some limitations to the fiscal forecast process exist, including uncertainties partly related to the national income accounts forecasts, considered to be a vital ingredient in the overall forecast process. Chapter 9 (Jones) suggests an analysis about the quality of public macroeconomic and revenue forecasts. Based on a unique dataset of outcome and forecast variables for Mozambique (1995–2005), this chapter shows that forecasts are persistently optimistic and have deteriorated for major variables over the period to date. In turn, Jones also shows that forecasts have not outperformed a relatively simple and naïve forecasting rule.

5 Taxation at the border

Chapters 10–13, corresponding to Part III, focus explicitly on tax policy issues at the border. Over the past two decades, Mozambique has proceeded with significant trade liberalization, seeking to deepen integration of its economy at regional and global levels. Under certain circumstances, economic integration may lead to a better allocation of resources and deliver welfare gains. An important dimension of economic integration is the extent to which price signals are transmitted correctly from one country to another. Chapter 10 (Cirera and Nhate) is an attempt to quantify the degree of price transmission from border to retail prices in Mozambique. The analysis uses data from the Customs authority to provide evidence at the micro or product-specific level on the determinants of consumer price changes. The principal finding here is that the exchange rate pass-through is high and symmetric (similar for appreciation and depreciation episodes). The results exposed in this chapter also demonstrate that other transmissi...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of figures
• List of tables
• Notes on contributors
• Preface
• Acknowledgements
• List of acronyms and abbreviations
• 1 Introduction and overview
• PART I Background and context
• PART II Institutional framework and current practices
• PART III Taxation at the border
• PART IV Domestic taxation
• Annex: documentation of social accounting matrix (SAM) development
• References