The purpose of tax policy, and taxation, is often questioned. The simple answer would be that taxation, whether direct or indirect, has always been seen as the most efficient way for governments to raise revenues. Today, taxation is more than just a revenue collection method. It is becoming ever more a means of attracting investment and luring talent.

Developing countries face mammoth challenges when designing tax policy and a number of important factors need to be taken into consideration both when developing a new policy or reforming existing ones:

Tax Levels

In order to determine the optimal tax level in a particular country, the optimal level of government spending would also need to be determined, as it is essential to keep tax revenues and government expenditure levels close together.

The data for the last 40 – 50 years show that the average level of taxes to GDP ratio in industrialised countries is almost twice that in developing countries. The data also show that whilst this average level has increased by about 4 -5 per cent in industrialised countries over the same period, this figure has remained more or less unchanged in developing countries, at about 17.5 per cent of GDP. The OECD Average stands just below 35 per cent.

The distortion between revenue and expenditure levels in developing countries has resulted in an increase in debt levels, as this is seen as the quickest way of raising finance as opposed to embarking on a long-term fiscal policy which is in line with the country’s economic vision. This increase in debt levels has in turn placed more pressure on the need to increase tax revenues and in the distortion between government expenditure and tax revenues.

In 2005, the UN Millennium Project advised developing countries that, on average, they need to increase the tax revenue to GDP ratio by an additional 4 percentage points from their current level of about 17.5%. This is still relevant today, also because the 17.5% level remains, more or less, unchanged.

Tax Structure

Another important factor is the composition of tax revenue and finding a balance between taxing income and consumption. Taxes on international trade also play an extremely important role in tax policy – the African Continental Free Trade Agreement (‘AfCFTA) will have a major impact on such taxes for a country like Rwanda.

There have been various schools of thought and conflicting theories on the optimal balance between taxation of income and taxation of consumption, and which of the two is deemed to be more efficient and equitable.

Like with anything else, the right balance has to be achieved. Here too, data suggests that there is a large disparity between the various tax structures in developing and industrialised countries. Developing countries place a higher reliance on indirect taxes as opposed to industrialised countries which place a higher reliance on income taxes as a percentage of total taxes.

A key consideration to keep in mind for developing countries is to minimise the tax burden, whether on income or consumption, for the poor. This can be achieved in various ways, for example, by having a tax-free bracket on progressive income tax rates which will not impact low-income families, or by having staple goods be zero-rated from an indirect taxation (typically, VAT) perspective.

Tax Administration

Tax policy, and its impact, is dependent on the strength (or weakness) of the country’s tax administration. In this aspect a couple of important considerations must be made. Firstly, education plays a key role in creating an efficient tax administration. Without the necessary knowledge, tax administrations will always fall behind when it comes to assessing and collecting tax revenues, which defeats the scope of having a tax policy in the first place.

Having a simple and transparent tax system will also result in improved tax administration. The more complex the tax system is, the more it is subject to abuse and negotiation, which is something countries want to steer away from.

Digitalisation

As businesses and transactions become more digital, developing countries must take advantage of this in their tax collection and administration processes. For a country like Rwanda, which has spearheaded the digitalisation process during the last years, integrating digitalisation in tax policy, and more importantly, in tax administration will result in a more efficient tax strategy not only in terms of tax collection, but also in terms of data collection. Data plays a key role in establishing a tax policy and developing it as time goes by – the lack of data in developing countries has always been a restrictive factor when developing tax strategy – as payments become more digital, this restriction will diminish and policy-makers will have the benefit of data when implementing and assessing existing policies.

Another important tax development which countries which are developing, or reforming, tax policy should pay close attention to, is the tax challenges arising from digitalisation. A lot has been said and discussed at both EU and OECD level and it is very likely that, during 2021, we will see major changes in international tax principles a result of taxing digital transactions. I tend to argue that countries which are undergoing a total revamp of their tax policy are at an advantage compared to other countries, in terms of understanding how to integrate these new international tax principles.

What remains certain is that developing a new tax policy or reforming an existing one comes with major challenges, particularly for developing countries. Tax policy cannot be looked at in a vacuum but must be thought out together with the country’s longer term economic vision. Tax policy is seen as not only a way to increase revenues, but also a tool to attract direct investment and talent in line with the country’s economic policy.

Nicky Gouder is a founding partnerof Seed, a research driven advisory firm based in Malta, Europe. (www.seedconsultancy.com)

nicky@seedconsultancy.com