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Revenue Composition and Growth

Written by: International Monetary Fund

Article Overview: An efficient and fair tax system is an important component of a progrowth strategy. While foreign aid can make an important contribution, the main source of finance for a country’s public expenditure must be its own tax revenue.

Revenue Composition and Growth

An efficient and fair tax system is an important component of a progrowth
strategy.19 While foreign aid can make an important contribution,
the main source of finance for a country’s public expenditure must be its
own tax revenue. This requires an effective tax administration and a tax
policy that minimizes distortions to ensure that the best use is made of resources
across the economy. To minimize distortions, tax systems should
avoid excessive complexity, focusing on taxing a broad range of goods and
services at relatively uniform rates. Income taxation also has a role to play,
although weak administrative capacity limits revenue from this source in
many developing countries. Tax systems should also be sensitive to the
possibility of market failure, not least in relation to the use of the environment
and natural resources, and be administered in a manner that is
transparent, impartial, and rules-based.

The tax system also needs to be accepted by domestic constituencies as
equitable, although experience has shown that taxation is generally less effective
than well-targeted spending programs in pursuing pro-poor policies.
The wealthy have proved adept in avoiding high tax rates on their income
by, for instance, locating assets abroad or taking advantage of relatively favorable
treatment of capital gains. Taxes on consumption and trade, which
are particularly important in many developing countries, are also blunt instruments
for pursuing equity objectives. For example, exempting some
basic foodstuffs from the value-added tax (VAT) certainly conveys some
benefit to the poor, since they are likely to spend a larger fraction of their
income on food. However, the rich may well spend a larger absolute
amount on the exempted good, so they derive the largest benefit. Removing
the exemption would yield revenue that could be spent in a more propoor
way,21 along the lines discussed in the section on “Fiscal Policy,
Human Development, and the MDGs.”
Improving the efficiency and equity of tax systems is a critical component
of IMF-supported programs. Almost three-fourths of PRGF-supported
programs in low-income countries incorporate measures to broaden the tax
base and improve horizontal equity (treating taxpayers with similar incomes
equally) by, for example, removing exemptions and abolishing special
tax breaks for foreign investors. Many programs also seek to improve
tax efficiency by lowering or reducing the number of import tariff rates,
simplifying the structure of the personal income tax, or improving tax administration.
Similarly, some programs seek to improve equity by, for example,
increasing the progressivity of the personal income tax.22 The IMF
also continues to play a key role in the adoption and improvement of the
VAT, which has proved to be a key tax innovation for many developing
countries. By introducing modern methods of self-assessment, the VAT is
also seen as an important first step toward modernizing tax administration.

Fiscal Dimensions of Sustainable Development
Prepared for
World Summit on Sustainable Development
Johannesburg, August 26–September 4, 2002

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Article Tags: administrative capacity, blunt instruments, capital gains taxes, developing countries, distortions, domestic constituencies, equity objectives, excessive complexity, favorable treatment, fiscal policy, foodstuffs, foreign aid, income taxation, main source, market failure, mdgs, poor policies, public expenditure, tax administration, tax rates



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