Why Do Tax Systems Vary in Poor vs. Rich Countries?

November 8, 2005

Around the globe, tax systems vary dramatically. But the most striking difference is between rich and poor countries. 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.

This is puzzling. Economists widely agree that broadly based tax systems are superior, and over time we’d expect all countries to converge on the “best” tax systems thanks to global competitive pressure. But poor countries aren’t moving in that direction.

Why not? There are two theories. One says that poor countries don’t have broadly based taxes because they have corrupt and unresponsive political systems, and bad policymakers make bad tax policy. However, the other theory says that poor countries don’t tax broadly because it’s harder for them to monitor taxable activity—think of trying to monitor the income of street vendors in a village market. That means relying on easy-to-monitor taxes might make economic sense for them.

Which theory is right? According to a new NBER paper by Roger Gordon and Wei Li, the latter explanation—that poor countries’ can’t easily monitor taxable activity—does a much better job explaining the data. From the abstract:

Observed economic policies in developing countries differ sharply both from those observed among developed countries and from those forecast by existing models of optimal policies. For example, developing countries rely little on broad-based taxes, and make substantial use of tariffs and seignorage as nontax sources of revenue.

The objective of this paper is to contrast the implications of two models designed to explain such anomalous policies. One approach, by Gordon-Li (2005), focuses on the greater difficulties faced in poor countries in monitoring taxable activity, and explores the best available policies given such difficulties. The other, building on Grossman-Helpman (1994), presumes that political-economy problems in developing countries are worse, leading to worse policy choices.

The paper compares the contrasting theoretical implications of the two models with the data, and finds that the political-economy approach does poorly in reconciling many aspects of the data with the theory. In contrast, the forecasts from Gordon-Li model are largely consistent with the data currently available.

Interesting paper—though it may be bad news for the world’s poor. It’s hard to see how poor countries can get growth while relying on tax systems that raise most revenue through trade barriers (tariffs) and printing money (seignorage).

Read the full paper here (PDF).


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