Does Globalization Encourage Good Tax Policy?

January 17, 2006

In addition to rising prosperity, improved health and greater economic freedom, there may be another reason to praise globalization: it may lead to better tax systems.

At least that’s the conclusion of new NBER working paper from Profs. Joshua Aizenman and Yothin Jinjarak, “Globalization and Developing Countries – A Shrinking Tax Base?“.

As we’ve written before, tax systems in poor countries vs. rich countries are radically different. Rich countries tend to rely on broadly based tax systems that tax income or consumption, while poor countries rely more on tariffs, seignorage, and other non-tax revenue sources.

The reason is simple: efficient broad-based taxes are hard to collect in poor countries. Why? Because they have undeveloped banking systems, making audits and enforcement impossible (imagine trying to enforce an income tax on street vendors in a village market). Instead, they rely on economically harmful but easy-to-collect taxes like tariffs, fees and seignorage.

But according to the Aizenman and Jinjarak, as developing countries have globalized and become financially integrated with the world in recent decades, they’re leaving behind their inefficient old tax systems. From the abstract:

We see globalization as a process that induces countries to embrace greater trade and financial integration, and macro stabilization. This in turn should shift their tax base from “easy to collect” taxes [tariff, seigniorage, etc.] towards “hard to collect” taxes [VAT, income tax, etc.].

We confirm this prediction — the revenue/GDP ratio of the “easy to collect” taxes declined by about 20% in developing countries between the early 1980s and the late 1990s, while the revenue/GDP of the “hard to collect” taxes increased by 9%.

Read the full paper here. (Link via New Economist.)

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