Many governments that want to achieve a sustainable economic recovery from the pandemic need to raise significant revenue in the fairest way possible. Personal income tax – levied on wages, salaries and other income – is an appropriate instrument to meet this challenge. In new research, we examine the potential for greater use of this tax tool in developing countries, where many people earn their living on low incomes.
Still in its infancy, but growing
Personal income tax had become the predominant tax on the eve of World War II in many advanced economies, where it now raises around 9% of gross domestic product. As well as providing income, it is progressive – imposing higher rates on those with higher income – and measurably reduces inequality.
In most emerging markets and low-income countries, however, such taxes are still in their infancy. Income from this source represents on average only 2.5% of GDP in these countries, in part because of their narrow tax base, and this does little to reduce inequality.
But gradual changes have taken place. In the two decades before the pandemic, income tax revenue more than doubled in low-income countries, from the equivalent of 1% of GDP to 2.1%, while emerging markets recorded an increase from 2.1% to 3.1%. These were also reflected in the tax’s share of overall tax revenue, which rose from 5% to 8% of total tax revenue in low-income countries and from 9% to 11% in emerging markets.
Our research on these advances focuses on three questions: what drives personal income tax growth, how increases affect total revenue performance, and how these levies influence income redistribution. Our findings contain important lessons for developing countries, particularly as they grapple with the post-pandemic challenge of building capacity to raise more tax revenue.
What drives revenue growth?
Looking at the evolution of personal income tax in developing countries, we distinguish observable changes in tax policy and broader economic changes. The policy changes targeted the upper and lower statutory rates as well as the level of exempt income. Remarkably, we find that this has not contributed much to rising incomes in low-income countries.
And in emerging market economies, this change has sometimes actually reduced incomes. This is partly the case because many emerging markets have implemented flat tax systems with low rates and those with progressive scales have reduced their rates over the past two decades.
Economic variables, on the other hand, played a very important role. We looked at the increase in per capita incomes and the size of the public sector wage bill and the reduction in the size of the informal sector, measured by the share of the self-employed in the labor force and the share of agriculture in the economy. These developments have clearly been the driving force behind the growth in personal income tax revenues. As economies develop, it can be expected that this tax will become increasingly important.
Improvements in tax administration can also play a role in raising revenue, although this extends to other taxes as well. Additionally, the accelerated shift to digitized services due to the pandemic may pave the way for better income tax design and enforcement.
What about the redistributive impact of income tax in developing countries? To explore this, we separate the effects of policy design from the size of the population covered by the tax. Interestingly, the design of this tax in low-income countries is generally progressive; rather, it is the narrow coverage that makes the overall contribution to redistribution very small compared to that observed in advanced economies. In emerging markets, however, it is not progressive. There would therefore seem to be significant potential for improving inclusion in this latter group of countries (several of which have a flat income tax).
Is it possible to increase personal income tax revenue in the post-pandemic recovery?
To answer this question, we look at how Additional income comes from alternative sources. Again, there is a big difference between advanced economies, where additional revenue comes mainly from income tax, and low-income countries, where it plays a much smaller role. Other taxes are therefore likely to play an important role in raising revenue over the medium term, with value added tax and other indirect taxes remaining the main contributors.
But income taxes can still be important for inclusive growth if they are well designed and the revenues are well spent. Our research, along with the history of taxation in advanced economies, shows that personal income tax is expected to become a more important source of revenue as countries develop.
*About the authors:
- Dora Benedek is Deputy Division Chief of the Fiscal Policy Division 2 of the IMF’s Fiscal Affairs Department. She undertakes research and leads capacity building missions on tax policy.
- Juan Carlos Benitez is a Technical Assistance Advisor in the Tax Policy Division 2 in the Department of Tax Affairs. As such, it contributes to the development of countries’ capacities on tax policy issues. He also undertakes research projects, mainly focused on direct taxation.
- Charles Vellutini is a Senior Economist in the IMF’s Fiscal Affairs Department. He has advised governments on tax and trade policy for over 15 years. He has contributed to the improvement of personal income tax, VAT, SME taxation, tax expenditures and other tax policy topics. His research has focused on the redistributive capacity of taxation, tax policy in fragile states, and general equilibrium analysis of tax policy. He has been a consultant for the European Commission and the World Bank and has taught at the Toulouse School of Economics.
Source: This article was published by the IMF Blog