Composition of Tax Revenue
Turning to the composition of tax revenue, we find ourselves in an area of conflicting theories. The issues involve the taxation of income relative to that of consumption and under consumption, the taxation of imports versus the taxation of domestic consumption. Both efficiency (whether the tax enhances or diminishes the overall welfare of those who are taxed) and equity (whether the tax is fair to everybody) are central to the analysis.
The conventional belief that taxing income entails a higher welfare (efficiency) cost than taxing consumption is based in part on the fact that income tax, which contains elements of both a labor tax and a capital tax, reduces the taxpayer's ability to save. Doubt has been cast on this belief, however, by considerations of the crucial role of the length of the taxpayer's planning horizon and the cost of human and physical capital accumulation. The upshot of these theoretical considerations renders the relative welfare costs of the two taxes (income and consumption) uncertain.
Another concern in the choice between taxing income and taxing consumption involves their relative impact on equity. Taxing consumption has traditionally been thought to be inherently more regressive (that is, harder on the poor than the rich) than taxing income. Doubt has been cast on this belief as well. Theoretical and practical considerations suggest that the equity concerns about the traditional form of taxing consumption are probably overstated and that, for developing countries, attempts to address these concerns by such initiatives as graduated consumption taxes would be ineffective and administratively impractical.
With regard to taxes on imports, lowering these taxes will lead to more competition from foreign enterprises. While reducing protection of domestic industries from this foreign competition is an inevitable consequence, or even the objective, of a trade liberalization program, reduced budgetary revenue would be an unwelcome by-product of the program. Feasible compensatory revenue measures under the circumstances almost always involve increasing domestic consumption taxes. Rarely would increasing income taxes be considered a viable option on the grounds of both policy (because of their perceived negative impact on investment) and administration (because their revenue yield is less certain and less timely than that from consumption tax changes).
Data from industrial and developing countries show that the ratio of income to consumption taxes in industrial countries has consistently remained more than double the ratio in developing countries. (That is, compared with developing countries, industrial countries derive proportionally twice as much revenue from income tax than from consumption tax.) The data also reveal a notable difference in the ratio of corporate income tax to personal income tax. Industrial countries raise about four times as much from personal income tax than from corporate income tax. Differences between the two country groups in wage income, in the sophistication of the tax administration, and in the political power of the richest segment of the population are the primary contributors to this disparity. On the other hand, revenue from trade taxes is significantly higher in developing countries than in industrial countries.
While it is difficult to draw clear-cut normative policy prescriptions from international comparisons as regards the income-consumption tax mix, a compelling implication revealed by the comparison is that economic development tends to lead to a relative shift in the composition of revenue from consumption to personal income taxes. At any given point of time, however, the important tax policy issue for developing countries is not so much to determine the optimal tax mix as to spell out clearly the objectives to be achieved by any contemplated shift in the mix, to assess the economic consequences (for efficiency and equity) of such a shift, and to implement compensatory measures if the poor are made worse off by the shift.
Turning to the composition of tax revenue, we find ourselves in an area of conflicting theories. The issues involve the taxation of income relative to that of consumption and under consumption, the taxation of imports versus the taxation of domestic consumption. Both efficiency (whether the tax enhances or diminishes the overall welfare of those who are taxed) and equity (whether the tax is fair to everybody) are central to the analysis.
The conventional belief that taxing income entails a higher welfare (efficiency) cost than taxing consumption is based in part on the fact that income tax, which contains elements of both a labor tax and a capital tax, reduces the taxpayer's ability to save. Doubt has been cast on this belief, however, by considerations of the crucial role of the length of the taxpayer's planning horizon and the cost of human and physical capital accumulation. The upshot of these theoretical considerations renders the relative welfare costs of the two taxes (income and consumption) uncertain.
Another concern in the choice between taxing income and taxing consumption involves their relative impact on equity. Taxing consumption has traditionally been thought to be inherently more regressive (that is, harder on the poor than the rich) than taxing income. Doubt has been cast on this belief as well. Theoretical and practical considerations suggest that the equity concerns about the traditional form of taxing consumption are probably overstated and that, for developing countries, attempts to address these concerns by such initiatives as graduated consumption taxes would be ineffective and administratively impractical.
With regard to taxes on imports, lowering these taxes will lead to more competition from foreign enterprises. While reducing protection of domestic industries from this foreign competition is an inevitable consequence, or even the objective, of a trade liberalization program, reduced budgetary revenue would be an unwelcome by-product of the program. Feasible compensatory revenue measures under the circumstances almost always involve increasing domestic consumption taxes. Rarely would increasing income taxes be considered a viable option on the grounds of both policy (because of their perceived negative impact on investment) and administration (because their revenue yield is less certain and less timely than that from consumption tax changes).
Data from industrial and developing countries show that the ratio of income to consumption taxes in industrial countries has consistently remained more than double the ratio in developing countries. (That is, compared with developing countries, industrial countries derive proportionally twice as much revenue from income tax than from consumption tax.) The data also reveal a notable difference in the ratio of corporate income tax to personal income tax. Industrial countries raise about four times as much from personal income tax than from corporate income tax. Differences between the two country groups in wage income, in the sophistication of the tax administration, and in the political power of the richest segment of the population are the primary contributors to this disparity. On the other hand, revenue from trade taxes is significantly higher in developing countries than in industrial countries.
While it is difficult to draw clear-cut normative policy prescriptions from international comparisons as regards the income-consumption tax mix, a compelling implication revealed by the comparison is that economic development tends to lead to a relative shift in the composition of revenue from consumption to personal income taxes. At any given point of time, however, the important tax policy issue for developing countries is not so much to determine the optimal tax mix as to spell out clearly the objectives to be achieved by any contemplated shift in the mix, to assess the economic consequences (for efficiency and equity) of such a shift, and to implement compensatory measures if the poor are made worse off by the shift.
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