When public deficits need to be reduced, the economic cost of raising more revenue must be weighed against the cost of cutting public spending. More revenue and less spending will both be needed as a rule. The temptation in the short-term is to rely on ad hoc increases in revenue because they are administratively and politically convenient. But in many countries this approach has led to complex and highly distortionary revenue systems that not only fail to collect sufficient revenue but also damage long-term growth. Even in the absence of fiscal deficits, tax reform may be necessary, especially when price regulations and barriers to market competition are being removed or when there is a case for rectifying an accumulation of ad hoc distortionary tax measures.
This strategy features in the framework of Agenda 21 as formulated at UNCED (Rio de Janeiro, 1992), now coordinated by the United Nations Commission on Sustainable Development and implemented through national and local authorities.
In general the economic cost of taxation increases with the tax rate and is higher when the base is narrow, as is the case in most developing countries. Reforms in developing countries such as Colombia, Indonesia, Jamaica and Malawi have concentrated on expanding the base, thus avoiding higher tax rates and adverse effects on incentives. To make the tax structure more transparent and to ease administration and enforcement, reforms have also favoured fewer rates and fewer exemptions. They have tried to promote equity by improving the collection of taxes from the wealthy through limited exemptions and improved tax administration and by avoiding taxes on the poor.
Successful tax reforms have demonstrated that variants of the value added tax (VAT) can generate substantial revenue with fewer distortions than import, turnover or excise taxes. Joint reform of trade and commodity taxes is particularly effective in meeting the dual goals of raising revenue and reducing inefficiency.
Many developing countries have a limited capacity for administration, so tax reform must be confined to what is administratively feasible. In most developing countries, especially the poorer ones, simplicity is essential; in particular, progressive income taxes are hard to collect. However, modern techniques, such as the use of computers and tax identification codes, can make it easier to collect most taxes. In fact, despite the technical problems, automation may eventually offer the most effective way to deal with expanded workloads in customs departments (with the growing volume and complexity of international trade), income tax departments (with the growing number of taxpayers) and treasuries (which need to forecast and monitor revenues). Such systems are currently being set up in Indonesia, Jamaica, Malawi and Morocco and are already partially or fully operational in Brazil, Ecuador, Honduras, Korea, and Nigeria. Experience suggests that automation can increase the efficiency of well-run operations, but it can exacerbate problems if superimposed on badly organized administrations.
Another approach is to improve information exchange among tax-collecting agencies. Exchange of information between revenue departments is highly advisable because gross sales figures are important in determining income tax liabilities, and valuations of sales for income tax purposes make it easier to implement ad valorem excises and duties. However, in both developing and industrial countries, import duties and taxes on domestic transactions or sales and income taxes may be administered by separate departments, with little or no exchange of information. Although a totally linked, self-checking system of taxes is still not possible, the availability of personal and mini-computers makes the use of self-enforcing taxes, matching information from different sources, more feasible. It is now possible for information furnished by one taxpayer to reveal the receipts and gains made by other taxpayers, as, for example, in a VAT.
A tax analysis unit can support policymakers by analysing the revenue consequences of changes in exchange rates, interest rates and trade and industrialization policies - all of which affect tax bases and interact with tax rates. It can also weigh the implications of new revenue measures for other policies and forecast revenue to assist in fiscal planning. Such units feature in many tax reform programmes.
Country-specific needs will determine whether comprehensive or partial reform is required. Comprehensive reforms need not be avoided on the grounds of overloading administrative capacity. The elements of a comprehensive reform can be introduced simultaneously or in stages in the light of revenue and administrative constraints. New tax instruments have been introduced successfully, as in Colombia and Korea. However, implementing a tax change is likely to be easier if the reform builds on existing tax instruments, as in India and Malawi.
Most tax systems could be restructured to increase yield, reduce distortions and minimize the burden on the poor. Carefully designed tax reform can reduce the cost of raising additional revenue and ensure that tax policy complements other policies. Administrative procedures, capabilities for data processing and analysis, and staff training must be improved in all types of tax reform. A reform that eliminates multiple adjustments to the base of a tax and reduces the number of rates can go a long way toward improving administration. Increased administrative costs, however, may sometimes be justified to lower economic costs, for example, by shifting from trade taxes to a VAT. Careful reform of revenue instruments can enhance their contribution to revenue and minimize their social and economic costs. But the remaining costs of raising revenue, in effect, set a floor to the benefits required from public spending. Accordingly, revenue should be planned jointly with spending: cost-benefit considerations apply to both parts of the budget.