0.21 Taxation and development

Worldwide evidence indicates that good tax policy can play a useful role in promoting growth and in providing resources to improve education, health and if carefully done even income distribution. But, while sensible tax policy is critical in providing an overall policy environment for facilitating growth, not even the very best tax policy can drive growth by itself.

Consider again a fundamental point: Sustained growth requires above all steady growth in productivity and therefore strong growth in Capital formation, including human, physical, intangible capital, and under some circumstances, natural capital.

Shortsighted tax policy can have very serious adverse effects on growth, by discouraging capital-formation. Thus, tax policy that impinges least on productivity favors economic growth. At the same time, there is a need to keep the tax system off the backs of the poor. For reasons and other reasons in patterns of taxation have been evolving, mostly for the better, over the past few decades.

Trends in taxation

Worldwide, there has been a very marked shift toward consumption taxes. At the same time there has been a shift from heavy taxation based on income, especially taxes in capital income , in a world where capital is mobile internationally.

The most significant feature of these shifts, by far, has been ever growing reliance on the Value-Added Tax (VAT) across the world, with somewhat lesser reliance on income taxes, imposed at lower rates than in the first two decades after World War II. The VAT is merely an advanced type of sales tax.

Four principal reasons account for the rapid expansion in the rate of this tax in Europe, Asia, Africa and Latin America.

1. We will see that as a consumption tax, the VAT has a smaller retarding effect on capital formation that a revenue equivalent income taxes.
2. The VAT has been a proven revenue workhouse almost everywhere it has been adopted
3. The VAT has fewer adverse effects, relative to income taxes on key incentives to work, save, invest and take risks. Consider corporate income taxes. They are imposed on profits, something that firms try to maximize. Income taxes lead firms to adjust to taxes, including changing output and thus income. But a VAT is imposed on Value-added. No firm tries to maximize value-added.
4. A simplified VAT is easier and cheaper to administer and collect than personal or corporate income taxes.

Effects on capital formation

Income taxes penalize saving, relative to a broad based consumption tax of equal revenue yield. The overwhelming majority of nations, even emerging ones, utilize a two-tier income tax structure. The first tier is an income tax on corporate profits. The second tier is a personal income tax levied on all income of individuals including dividends already taxed at the corporate level, and including income of single proprietorship and income from business partners.

Savings are, in effect taxed twice under such an income tax structure. The base of the corporate tax is corporation profits, after all labor and market expenses are paid but before dividends to individual stockholders are distributed. Then previously taxed dividends are taxed again under the personal income tax. Some of these dividends will be used for consumption, but some portion would be saved. This is what is usually meant by the double taxation of savings under an income tax.