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Asia & the Pacific Policy Studies, vol. 2, no. 1, pp. 169–182
doi: 10.1002/app5.70
Original Article
Taxation Challenges in Developing Countries
Michael Carnahan*
Abstract
A well-functioning revenue system is a neces-
sary condition for strong, sustained and inclu-
sive economic development. However, the
revenue systems in some developing countries
have fundamental shortcomings. Using Public
Expenditure and Financial Accountability
assessment data, this article provides a
summary of the revenue raising capabilities
across 58 developing countries. Tax reforms or
tax system changes need to be made mindful of
that current capacity. The optimal choice of tax
regime may be different when administrative
capacity is low. The increasing globalisation of
economic activity adds a further layer of com-
plexity that developing countries need to
manage in building and maintaining their
revenue systems. Finally, any proposals to
change the revenue system in a developing
country need to recognise that, like developed
countries, tax reforms are highly political
endeavours.
Key words: tax policy, tax administration, tax
reform, developing countries, fiscal policy
* Chief Economist (Development), Australian
Department of Foreign Affairs and Trade, GPO
Box 887, Canberra, ACT 2601, Australia. The
author is writing in a private capacity; email
⬍michael.carnahan@dfat.gov.au⬎.
published by Crawford School of Public Policy at The Australian National University and Wiley Publishing Asia Pty Ltd.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License,
which permits use and distribution in any medium, provided the original work is properly cited, the use is non-commercial
1. The Centrality of Taxation to Economic
Development and Poverty Reduction
A well-functioning revenue system is a neces-
sary condition for strong, sustained and inclu-
sive economic development. Revenue funds
the public expenditure on physical, social and
administrative infrastructure that enables busi-
nesses to start or expand. The revenue system
is also a central element in supporting a strong
citizen–state relationship that underpins effec-
tive, accountable and stable governments.
Both of these elements contribute to stronger
economic and employment growth outcomes.
There is general consensus around the
importance of basic public goods to economic
development. Without safety and security, few
people will invest; why forgo real resources
today when there is little likelihood that you
will be able to secure the returns on that invest-
ment tomorrow? A functioning corporate and
regulatory system reduces the costs for busi-
ness and supports their expansion. Transport,
communications and energy infrastructure are
critical components for many large and small
businesses. Access to health and education ser-
vices means that workers are more productive
and take less time out of the workforce to care
for families. A social safety net encourages
risk taking, innovation and labour mobility.
There are debates about the extent of public
good provision—what constitute basic public
goods. There is also a debate over how some of
these public goods should be financed; what is
the balance between user pays and funding
from general revenue? But this is a matter of
degree; the provision of a set of core public
© 2015 The Author. Asia and the Pacific Policy Studies
and no modifications or adaptations are made.
170 Asia & the Pacific Policy Studies
goods funded from general revenue underpins
stronger economic development.
There is also increasing interest in the rela-
tionship between revenue and the nature of
state formation and state fragility. Stable and
functioning states are needed to provide these
essential public goods. However, the collection
of revenue does more than fund these states.
Rather, there is an increasing focus on the role
of revenue collection as central in building the
state–citizen relationship. It is this relationship
that is key in establishing an accountable,
responsive and ultimately legitimate state.1
The coincidence of state fragility or failure
with very weak revenue performance has
piqued interest in the state formation literature.
In particular, the relative ineffectiveness
of governments in fragile states, together
with their reliance predominantly on natural
resources or foreign aid for revenue has raised
the question of whether there would be a ‘gov-
ernance dividend’2 from a stronger focus on
domestic taxation.
Writing in the early twentieth century,
fiscal sociologists, led by Schumpeter and
Goldscheid, argued that societies evolved in
response to the way that states raised revenues
and managed expenditures. Schumpeter
argued that a major driver of the great transi-
tion in modern Western Europe was the move
to fund expenditure from taxing the private
sector and private incomes, away from rev-
enues generated by the ruler’s properties.
There are significant differences in the
context facing current developing countries to
that which faced Western Europe over the
latter half of the last millennium. Moreover,
there is not an agreed or comprehensive ana-
lytical framework for the study of state forma-
tion writ large, let alone one that incorporates
1. Much of the focus in this area has been on the relation-
ship between the citizen–state relationship and the raising
of domestic revenue. The OECD (2009) also note that
taxation can also improve governance by creating a shared
interest in economic growth between the state and the
private sector, and that the improvements in the state appa-
ratus associated with improved revenue collection may
spur improvements elsewhere in the state apparatus.
2. Easter (2002) coins the term ‘governance dividend’ in
his discussion on the politics of revenue extraction in
Russia and Poland after the fall of the Soviet Bloc.
© 2015 The Author. Asia and the Pacific Policy Studies
published by Crawford School of Public Policy at The Australian National University and Wiley Publishing Asia Pty Ltd
January 2015
the role played by domestic revenue forma-
tion. Nevertheless, there is a growing consen-
sus that a greater focus on domestic revenue
can build stronger citizen–state relations and in
that way contribute to more accountable and
responsive states—even in the absence of a
general theory explaining it.3
How development partners can support
developing countries to do this in a way that
recognises their political and administrative
contexts is the focus of the remainder of this
article. The next section discusses the current
state of capability in tax administration in
developing countries. Against this back-
ground, the following section discusses some
of the challenges and tradeoffs developing
countries face. Section 4 discusses the impact
of increasing globalisation on developing
country revenue raising. Finally, in Section 5,
the political economy challenges facing all
jurisdictions are briefly discussed.
2. The Current State of Capability in
Revenue Administrations
There is growing international interest in
improving the ability of developing countries
to collect domestic revenue. However, the evi-
dence on the current capability of revenue
authorities in developing countries to perform
basic functions is mixed. Obtaining compa-
rable evidence across countries is not straight-
forward. A McKinsey benchmarking study of
tax administrations in 2008–09 found that tax
administrations in 13 countries could collect
an additional $86 billion by improving the effi-
ciency of their tax administrations (Dohrmann
& Pinshaw 2009). However, such reports rep-
resent the exception rather than the rule.
For the following discussion, I use data col-
lected as part of the Public Expenditure and
Financial Accountability (PEFA) assessment
process Eckardt and Schickinger (2012) use
PEFA assessments to undertake a similar study
on a different group of countries. The PEFA
program was founded in 2001 to assess the
3. For a fuller discussion of this see, for example, Moore
(2004).
 Carnahan: Taxation Challenges in Developing Countries
condition of country public expenditure, pro-
curement and financial accountability systems
and develop a practical sequence for reform
and capacity-building actions. The PEFA tool
is an assessment framework against 28 key
public finance capabilities. Capability is
assessed on a four point (A–D) scale.
Four of these capabilities directly relate to
the revenue system: PI-3—Aggregate revenue
out-turn compared with original approved
budget; PI-13—Transparency of taxpayer obli-
gations and liabilities; PI-14—Effectiveness
of measures for taxpayer registration and tax
assessment; and PI-15—Effectiveness in col-
lection of tax payments.
In general, developing countries perform
quite well on actual revenue collections
against targets. The rest of this section dis-
cusses performance against the other three
capabilities. For the purposes of this article,
only PEFA assessments carried out since 2010
were used. Where there was more than one
assessment, the most recent assessment was
used. In his period, 58 assessments were
undertaken globally, and 17 of those were in
countries in the Asia-Pacific region.
2.1 Transparency of Taxpayer Obligations
and Liabilities (PI-13)
Indicator PI-13 assesses whether taxpayers are
aware of their obligations and liabilities. It has
three subcomponents: clarity and comprehen-
siveness of liabilities; taxpayer access to infor-
mation on tax liabilities and administrative
procedures; and whether a functioning appeals
system operates. The overall assessment of
countries is presented in Figure 1.
Figure 1 Transparency of taxpayer obligations and
liabilities (PI-13).
60%
40%
All countries
20%
Asia Pacific
0%
A B C D
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In two thirds of the assessed countries,
taxpayers had a good understanding of their
obligations and liabilities. The ratings were
slightly lower for the Asia-Pacific region.
Ratings of B reflect taxpayers having informa-
tion on their liabilities and obligations for most
of the major taxes that they face. C ratings
reflect a less comprehensive coverage, with
only some of the major taxes covered.
2.2 Effectiveness of Measures for Taxpayer
Registration and Tax Assessment (PI-14)
If taxpayers know their obligations, the second
question for a revenue system is whether those
obligations can be effectively assessed. The
second aspect of the revenue system involves
registering and assessing taxpayers, based on
their legal obligations. This indicator also has
three subcomponents: whether the registration
system has appropriate controls to ensure
comprehensive registration of taxpayers with
appropriate linkage across tax database and
other regulatory and financial databases;
whether penalties for noncompliance with reg-
istration and declaration obligations are set
appropriately and consistently administered;
and whether there is an audit and fraud inves-
tigation program based on clear risk assess-
ment criteria (Figure 2).
Figure 2 Effectiveness of measures for taxpayer reg-
istration and tax assessment (PI-14).
80%
60%
40% All countries
20% Asia Pacific
0%
A B C D
Just under half of the assessed countries
are rated as A or B. In the Asia-Pacific, over
80 per cent of the countries are rated as a C or
D. Comparing PI-13 and PI-14, in 20 per cent
of the countries, taxpayers had a good under-
standing of their obligations but the countries
© 2015 The Author. Asia and the Pacific Policy Studies
172 Asia & the Pacific Policy Studies
were not effective at registering and assessing
those obligations.
Under this indicator, countries are rated as a
C when taxpayers are registered in database
systems for individual taxes, but these data-
bases are not fully or consistently linked; when
non-compliance regimes exist but need sub-
stantial reforms to have a real impact on com-
pliance; or when the audit program is not
based on any risk assessment criteria.
2.3 Effectiveness in Collection of Tax
Payments (PI-15)
For a revenue administration to be effective,
taxpayers need to know their obligations, have
those obligations assessed and then have actu-
ally pay their assessed obligations. The third
indicator assesses the effectiveness of the
actual tax collection. Indicator PI-15 assesses
the collection ratio for gross tax arrears, the
effectiveness of the transfer to the Treasury by
the revenue administration and the frequency
with which there is a reconciliation between
tax assessments, collections, arrears and
receipts by the Treasury (Figure 3).
Figure 3 Effectiveness in collection of tax payments
(PI-15).
100%
80%
60%
40% All countries
20% Asia Pacific
0%
A B C D
In 65 per cent of countries, taxpayers have a
good understanding of their obligations. In
45 per cent of countries, taxpayers obligations
are assessed effectively. However, only in
25 per cent of countries are tax payments col-
lected effectively. The results in the Asia-
Pacific region are weaker.
Under this indicator, countries are assessed
as a D when the debt collection ratio in the
most recent year was below 60 per cent and
tax arrears were significant, when revenues
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January 2015
are transferred to the treasury less frequently
than monthly or when the complete recon-
ciliation of accounts either does not take
place or is done with more than a three month
delay.
While the best available source of informa-
tion, these assessments are far from compre-
hensive. However, they provide a degree of
insight into the quite fundamental nature of the
administrative and capacity challenges that
many developing countries face. Any propos-
als to change policies, or introduce new admin-
istrative requirements need to be considered
within the context of the current capacity in
these administrations. It is against this back-
ground that the subsequent sections of this
article are written.
The new Tax Administration Diagnostic
Assessment Tool (TADAT) will provide a
standardised and objective assessment of
the relative strengths and weaknesses of the
administration of a country’s tax system
(IMF 2013). TADAT has its origin at the G20
Seoul Summit in 2010. The Summit mandated
the International Monetary Fund (IMF),
Organisation for Economic Cooperation and
Development (OECD), UN and World Bank to
identify constraints faced by tax administra-
tions and suggest measures for capacity build-
ing. This led the G20 Development Working
Group to recommend that all interested parties
operating in the tax field should work together
to develop a core set of indicators that would
support meaningful monitoring and assess-
ment of capacity improvement in tax adminis-
tration and other revenue-related areas.
TADAT follows the PEFA approach of
assessing performance in nine specific areas:
efficiency of tax administration; tax dispute
resolution; accuracy of reporting; filing of
returns; payment of obligations; accountability
and transparency; integrity of the taxpayer
base; assessment of risk; and supporting vol-
untary compliance. In each category, there are
specific subindicators and each indicator will
be scored against clear-cut criteria on an A
to D scale. This approach will allow for a
more structured diagnosis and the develop-
ment of country-specific plans to improve
revenue systems.
© 2015 The Author. Asia and the Pacific Policy Studies
 Carnahan: Taxation Challenges in Developing Countries
3. Dealing with Capability, Compliance
and Change in Developing Country
Tax Systems
Tax reform looks to balance economic, com-
pliance and administrative costs when raising
adequate revenue. These play out differently
across different tax bases in developing
countries.
In assessing administrative costs, three
aspects need to be considered: the number of
transactions; the complexity of each transac-
tion; and whether there was a natural or easy
point for the transaction to take place. That is,
did the nature of the activity bring the taxpayer
into contact with the state administration in a
natural way, or did engagement with the tax-
payer rely either on a voluntary action by the
taxpayer or a proactive action by the revenue
authority?
Comparing the economic costs or economic
efficiency of different taxes can be more
complex. In general, the economic impact of a
tax is determined by the extent to which the
tax changes individual behaviour away from
the pre-tax situation. So the less a tax changes
people’s decisions (for a given amount of
revenue), the more economically efficient it is.
In the absence of specific information on how
people will change their choices, it is hard to
precisely compare the efficiency impact of
different taxes. Nevertheless, for the purpose
of this discussion, I will make some general
assertions around efficiency, in particular
arguing that generally broader and lower taxes
that cover a wider range of activities and tax-
payers will be more efficient than narrower or
more selective application of taxes.4
In this rest of this section, I consider some
issues with each of the three major tax bases
open to developing countries: consumption,
income and natural resources.5 The tax bases
4. For a more comprehensive discussion on this point see,
for example, OECD (2010).
5. The relative efficiency of taxing consumption versus
income remains contested in theory. Where there is agree-
ment is that this is an empirical issue. However, the like-
lihood of gaining data on elasticities that is sufficiently
credible to base decisions on is limited—particularly in
most countries of interest to Australia.
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173
are considered with two specific questions in
mind:
• How does the level of administrative capa-
bility impact on the appropriate choice of tax
instruments?
• How is the appropriate choice of taxes and
tax reforms impacted by the change in the
economic structure of a country as it devel-
ops? In particular, does the increasing com-
plexity of what is produced and the increase
in the formal sector as an economy develops
impact on the appropriate choice of taxes?
3.1 Taxing Consumption
What Are the Basic Tax Options?
Indirect taxes or taxes on consumption are a
mainstay of the revenue base. In terms of a
general tax on consumption, over 150 coun-
tries and all but one OECD country have
some form of value-added tax (VAT). A VAT
imposes a tax at each stage of the production
process which is then passed through to the
final consumer. Other forms of general con-
sumption taxes include a retail sales tax (RST),
where taxes are just imposed at the retail level
on sales of goods or services; a turnover tax,
where each stage of production is taxed; or a
services tax that just taxes specific services at
the retail level. Consumption of specific goods
is also taxed through specific excises. Finally,
tariffs on imports represent a tax on the con-
sumption of these imported goods.
Different consumption taxes have signifi-
cantly different economic impacts and admin-
istrative costs. Figure 4 presents a simple
schema to highlight the tradeoff between dif-
ferent ways to tax consumption.
The VAT, RST and turnover tax are gener-
ally applied to broader bases than tariffs,
excises or service taxes, so they will be more
economically efficient. Within this first group,
a VAT is considered to be the most economi-
cally efficient consumption tax. Under strict
assumptions,6 an RST and a VAT will have
identical efficiency impacts, but when these
assumptions are not met, in general a VAT will
6. Assumptions include perfectly competitive markets,
full information and perfect enforcement.
© 2015 The Author. Asia and the Pacific Policy Studies
174 Asia & the Pacific Policy Studies
Figure 4 Tradeoff between administration and efficiency costs – taxing consumption.
be more efficient. A simple turnover tax is
often less efficient because the tax paid at one
level cascades through to the next level. So the
overall tax on a good can be determined more
by the number of productive steps it passes
through than the actual value of the good.
Tariffs, excises and services taxes are less
economically efficient as they only apply to
a subset of goods or services. The relative
degree of inefficiency relates directly to
the extent of coverage. Tariffs are the least
economically efficient as they focus on goods
and exclude services, and tax consumption of
imported goods rather than consumption of
goods generally (Figure 4).
Given its comprehensive coverage, the
VAT is more difficult to administer—because
it applies to more taxpayers. Even in its sim-
plest form, it is more complex to administer,
because intermediate producers need to get
credit for the tax they pay. These complexities
are multiplied when there are multiple rates or
some products are ‘zero-rated’, while others
are exempt.
Conversely, import tariffs are the easiest to
administer because the border represents a
natural collection point. This is particularly the
case for island economies, but also the case in
many developing countries with limited trans-
port infrastructure.
An RST, turnover tax and a services tax sit
between these two extremes. A services tax has
been an attractive option in fragile or post-
conflict countries because of its ease of admin-
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January 2015
istration. It has regularly been applied to a
handful of visible services such as hotels, res-
taurants, telephony services and car rentals.
The visibility of the services and their placed
base nature makes administration simpler.
The fact that these services are predominantly
consumed by international staff in the devel-
opment industry makes it an easy tax to imple-
ment politically. An RST has fewer taxpayers
than a VAT, making it easier to administer. A
turnover tax will have the same number of
taxpayers as a VAT, but each taxpayer interac-
tion will be simpler. So such a tax is harder
to administer than an RST, but easier than a
VAT.
Excises have been an attractive option for
both developed and developing countries.
They generally are applied to a small number
of products, commonly alcohol, tobacco, fuel,
motor vehicles and telephony sources. They
are among the simplest taxes to administer,
although there can be significant enforcement
issues associated with smuggling. In many
cases, excises are highly efficient taxes as they
are imposed on goods where demand is rela-
tively inelastic. However, there are concerns
with the equity aspects of such an approach, if
the poor spend a relatively larger share of their
income on these goods.
What Are the Issues?
The 1990s saw a dramatic adoption of VATs
among developing economies: from around 20
to over 80. A further 20 developing economies
© 2015 The Author. Asia and the Pacific Policy Studies
 Carnahan: Taxation Challenges in Developing Countries
introduced a VAT during the following decade.
The IMF has been active in the promotion of a
VAT and Keen and Lockwood (2010) note that
the probability of a VAT is significantly related
to participation in a fund-supported program.
Most of the countries that do not have a
VAT have two unrelated things in common.
They have weak administrative capacity in
their revenue administration and they produce
a relatively small set of goods and services. In
considering reforms to consumption taxation
in developing countries, there is merit in
understanding what impact different economic
structures have on the relative efficiency of
different ways to tax consumption.
As countries become more developed, the
structure of their economy becomes more
diverse. They build greater capabilities and
produce a wider range of goods and services,
and the goods and services they produce are
more complex.7 In particular, they produce an
increasing number of intermediate goods and
services—that is goods or services that are an
input into the production of another good or
service.
As discussed, in the presence of interme-
diate production, a VAT avoids the distortions
associated with just taxing the final product,
or taxing the turnover at each stage of produc-
tion. However, in the polar case where there is
no intermediate production, a VAT, an RST
and a turnover tax will be identical. By way
of example, consider a simple economy where
final consumption is comprised of either
imported goods or locally produced agricul-
tural products. In such an economy, the three
taxes would collapse onto each other.
As an interesting aside, consider the case
in this economy if food was exempted from the
tax for political reasons. In such a case, a tariff
on the imported goods would be functionally
identical to the collapsed VAT/RST/turnover
tax.
The key choice for the country is: at what
level of economic development or economic
sophistication is the additional administrative
burden of a VAT worth incurring. The coinci-
dence of weak administrative capacity and
7. Hausmann et al. (2012).
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175
relatively unsophisticated economic structure
work together in this regard. In these countries,
the benefit of a VAT is more limited, and the
opportunity cost of applying scarce tax admin-
istration capacity to an unnecessarily sophisti-
cated tax, in terms of revenue foregone from
other tax bases, is much higher.
There are also dynamic issues that need to
be considered. Does the introduction of a VAT
catalyse improvements in the tax administra-
tion? Can the VAT threshold be used for tax-
payer segmentation, supporting more effective
direct taxation collection from small and
medium businesses? Does the VAT provide an
incentive for small and medium enterprises to
enter the formal economy in order to claim
refunds on intermediate products, with greater
formalising of the economy delivering benefits
beyond increased revenue? Or does the VAT
provide an additional burden that increases the
incentive for firms to remain in the informal
sector?
The best technical solution to most effec-
tive way to tax consumption in the 50 or so
countries without a VAT is not immediately
obvious. It will depend on the country
context, particularly around the economic
structure and the level of administrative
capacity. The key for development partners is
to help countries identify and develop the
appropriate solution, and then implement it.
Conversely, for the vast majority of develop-
ing countries that have introduced a VAT,
there is a range of specific reforms in design
and implementation that is obvious from a
technical perspective. In this case, the chal-
lenge is to stay engaged with the revenue
authorities to support them in the long game
of introducing these reforms.
3.2 Taxing Income
What Are the Basic Tax Options?
The primary sources of direct or income
taxation are individuals, through a personal
income tax (PIT), and companies through a
corporate income tax (CIT). Much of the
discussion around corporate taxpayers breaks
this group up into large taxpayers and small
businesses.
© 2015 The Author. Asia and the Pacific Policy Studies
176 Asia & the Pacific Policy Studies
The vast majority of PIT revenue comes
from wage withholding of employees—a much
smaller amount comes from the personal
income earned by other individuals, including
high wealth individuals. Revenues from a PIT
are quite low and stagnant in developing coun-
tries, around 1–2 per cent of gross domestic
product (GDP) compared with 9–11 per cent in
developed countries.8 Around 95 per cent of the
PIT collected in developing countries comes
from wage withholding by the public sector and
large corporates. Reflecting the structure of
many developing country economies, less than
5 per cent of the population pay PIT.
PITs are generally administered through a
wage withholding tax system where employers
withhold part of the employees’ wages and
remit that amount to the tax administration. In
some countries the system simply involves this
wage withholding. In other countries PIT tax-
payers submit tax returns periodically to rec-
oncile the tax withheld with their overall tax
liabilities. A simple wage withholding PIT is
relatively straightforward to administer when
it is limited to the public sector and large firms.
While there are a relatively large number of
individual taxpayers, each transaction is rela-
tively straightforward if the tax has few or no
exemptions or deductions.
Generally, a CIT is levied on the profit
earned by companies, that is the revenue they
generate less the deduction of allowable
expenses. On average, CITs make a larger con-
tribution to overall revenue in developing
countries—around 1.5–3 per cent of GDP.
They make a much smaller relative contribu-
tion to overall revenue in developed countries,
also contributing on average around 3 per cent
of GDP. Given the skewed distribution of
firms, large corporates make the major contri-
bution to this revenue.
Even a well-designed CIT applying to a
firm that is looking to comply with the law and
operating entirely in a national jurisdiction can
be complex to administer. While the revenue
side may be relatively straightforward, there
will be issues of interpretation and application
of judgement in determining the expenses—
8. Cottarelli (2011).
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January 2015
particularly around depreciation of assets. In
practice, many CITs are not well designed,
with multiple rates and complex depreciation
schedules.
Many developing countries have success-
fully established large taxpayer offices in order
to deal with what are predominantly a series of
low volume—high value transactions. One of
the reasons for the success of these large tax-
payer offices is the low volume—high value
nature of the transactions is actually amenable
to direct capacity supplementation from inter-
national technical assistance providers.9 The
focus on large corporates also supports the
successful implementation of a VAT and of
the PIT as the corporate generally remits both
the VAT payments and the withheld PIT pay-
ments to the revenue authority.
What Are the Issues?
Effectively segmenting the taxpayer base is
the key to allocating scarce administrative
capacity and capability to their best use. This
includes both domestic resources as well as
international assistance. As discussed, much of
the focus as has been on the high yielding large
corporates, including multinational enter-
prises. More recently, there has been increas-
ing attention on the aggressive tax planning
practices employed by some multinational
enterprises.
However, the focus needs to go beyond the
large corporates for two reasons: supporting a
broad level of compliance with the revenue
system and ensuring that there are necessary
barriers to corporate expansion or firms
moving from the informal to the formal sector.
In any successful revenue system, there
needs to be a culture of compliance among
taxpayers.10 Certainly, this culture can be
9. This is in contrast to many other aspects of revenue
administration, broader fiscal management or indeed gov-
ernment administration in general. Most of these situations
are characterised by low value—high volume transactions
which require capacity building rather than capacity
substitution, with the former being considerably more
difficult.
10. For a detailed discussion of the culture of compliance
and the balance between compliance and enforcement see,
for example, Braithwaite (2007).
© 2015 The Author. Asia and the Pacific Policy Studies
 Carnahan: Taxation Challenges in Developing Countries
sharpened by well-directed and publicised
enforcement actions. It can also be sharpened
by designing the system and educating taxpay-
ers in a way that reduces their compliance
costs. However, a further element in building
such a culture is the perception of fairness.
Specifically, compliance by large businesses
can be undermined if small or medium
businesses are not seen to pay a reasonable
amount. So too small and medium businesses
complying with their tax obligations may
reduce this compliance if they see other tax-
payers not complying—particularly their com-
petitors. In the same way if multinational
enterprises are seen to not be paying their way,
it impacts on compliance by domestic large
corporates and other businesses.
A particular challenge in many developing
countries is the relatively high level of eco-
nomic activity in the informal sector. This
raises a range of challenges beyond undermin-
ing compliance with the revenue system by
participants in the formal economy. The
weaker access to financial instruments and
larger markets has limited the scope for eco-
nomic expansion and has led to relatively
lower levels of economic growth in countries
with relatively larger informal sectors.
The art is in designing the revenue system
in a way that does necessarily put burdens in
the way of firms that want to expand and
make use of the opportunities presented in the
formal sector. However, this has policy impli-
cations beyond the revenue system. Designing
the regulatory framework in a way that
creates value and encourages firms to partici-
pate is also key. In many countries, the regu-
latory environment is designed to extract
rather than create value. Financial regulation
is particularly important. Good financial regu-
lation that encourages firms to operate within
this sector gives them greater access to capital
for expansion. It also is the critical source of
information for administering an effective tax
system.
Finally, the tax bases in both developing
and developed countries are under threat from
a number of sources. Base erosion and profit
shifting (BEPS) associated with multinational
firms is currently the most prominent among
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177
these. This issue is discussed in more detail in
Section 4. A second base erosion challenge for
all countries is the pressure to provide tax
incentives or tax holidays to attract investment.
The recent G20 communique has set a target of
lifting global growth by 2 per cent over five
years, and there is an associated push to
increase private investment to fuel this growth.
The push for a range of tax incentives to
support this increased private investment will
not be far away.
The evidence around the use of incentives
to attract investment is mixed. Business
surveys find that other factors such as rule of
law, infrastructure and labour matter more than
taxation. Particularly pertinent in the G20
context is whether tax incentives increase the
global supply of investment. Their major
impact may be to change the allocation of
investment across countries—with the global
impact being on the aggregate amount of tax
that corporations pay.
Tax incentives raise concerns around
revenue leakage in developing and developed
countries. Some types of incentives are likely
to be more successful than others, and generate
more benefits than others—for example, an
investment tax credit may be preferable to
simply exempting profits. Designing effective
tax incentives is a challenge for well-resourced
tax administrations in developed countries.
However, in developing countries with weaker
administrations, the likelihood for serious
revenue leakages and negative spillovers from
incentive schemes is much greater.
3.3 Resource Taxation
What Are the Basic Tax Options?
For many developing countries, natural
resources represent the only way to fund the
investments in human, physical and institu-
tional capital needed to produce sustained
improvements in standards of living and basic
development indicators. The taxation options
discussed in this section are in addition to any
corporate tax obligations that may be imposed
by the government. The bulk of the discussion
focuses on taxation of the mining sector, with
a brief discussion around land taxation.
© 2015 The Author. Asia and the Pacific Policy Studies
178 Asia & the Pacific Policy Studies
Figure 5 Tradeoff between administration and efficiency costs – resource taxation.
There are three basic options for taxing
mining projects: royalties; profit-based
royalty or tax and a resource rent tax. The
three options present clear tradeoffs between
administrative and economic efficiency
(Figure 5).
A unit-based royalty—applying a fixed
dollar rate to the physical production—is the
most straightforward tax to administer. Essen-
tially, it involves measuring the tonnage and
applying the rate. Corruption or maladminis-
tration is still possible, but an honest tax
administration does not need deep technical
capability to effectively implement this tax.
A value-based royalty involves applying a
fixed rate to the value of the minerals in the
ore sold by the miner. This can be either be
applied to the sales value of the minerals (as
included on the invoice) or on the gross value
of the metal/minerals contained in the ore.
However, these royalties do not lead to the
optimal exploitation of natural resources. They
are levied irrespective of the costs of produc-
tion, so economically efficient but more
expensive operations or risky investments are
discouraged.
A resource rent tax is the most economi-
cally efficient tax in terms of leading to the
exploitation of the natural resources in a way
that maximises the value of those resources.
Essentially, a resource rent tax is designed to
raise revenue for the community while not
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January 2015
changing the incentives that mining companies
face in terms of where or when they exploit
the natural resources. It does this by taxing the
notion of ‘economic rent’—essentially the
profit that is left after the mining company has
received the market rate of return on its capital
investment. While attractive in theory, the
implementation of a resource rent tax has
rarely been straightforward. The information
requirements lead to high administration and
compliance costs.
A profit-based royalty or tax applies to the
accounting profit realised by the project. In
this way, it is similar to a CIT, except that it is
generally applied at the project level rather
than aggregated across all the projects and
other activities of the corporation. Because the
profit-based tax taxes both the natural resource
and the return on the mining company’s
capital, it leads to the suboptimal exploitation
of the country’s natural resources.
Land taxes have historically been seen as
highly efficient and equitable. A tax on the
value of land is simple to administer and dif-
ficult to avoid. As land is in fixed supply, the
imposition of the tax does not alter the amount
of land that is in existence. So unlike taxes on
capital or labour, the tax does not change peo-
ple’s decisions. The positive correlations
between property ownership, income and
wealth make land taxation a very progressive
tax.
© 2015 The Author. Asia and the Pacific Policy Studies
 Carnahan: Taxation Challenges in Developing Countries
What Are the Issues?
Resource taxation is potentially complex and
often involves large multinational corporations
and significant amounts of money. In devel-
oped countries with sophisticated tax adminis-
trations, there are few examples where
resource rent taxes have been used to raise
revenue. In developing countries with much
weaker tax administrations, there are very
strong arguments for supporting royalties-
based approaches. This can generate strong
and relatively stable revenue flows even with
relatively low levels of administrative capa-
city. Scarce administrative resources can be
directed to basic anti-corruption and anti-
evasion endeavours, rather than calculating tax
liabilities and ensuring compliance with a
complex law. In simple terms, a less efficient
tax administered well serves the public interest
better than an efficient tax administered
poorly.
Land taxes make a small contribution to
the overall tax take in developing countries.
Land taxes have traditionally been seen as a
tax for local governments to administer—in
part because the value of the land reflects the
provision of public services. However, there
are legitimate questions about whether land
tax should be given greater prominence, in
small states—especially in the absence of
other tax bases.
In some countries, confusion or contest
over land ownership has presented challenges
in implementing land taxation. This has been
particularly difficult in post-conflict situations.
However, the uncertainty over land tenure
provides an opportunity. Land taxes are
notoriously hard to introduce because of the
significant political power and influence
wielded by landowners. But with tenure con-
tested, there is an opportunity to put the tax on
the books, build the collection capacity and
then actually collect when ownership is
settled.
4. The Impact of Globalisation on
Developing Country Revenue Systems
Globalisation has changed the nature of
economic activity and it has increased the
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179
challenges faced by revenue authorities. Like
developed countries, developing countries
need to deal with the challenge of BEPS.
Moreover, taxpayers resident in a country may
be arranging their affairs so that they are com-
pletely hidden from the domestic revenue
authority. The Automatic Exchange of Infor-
mation (AEOI) project seeks to address
this issue. The main difference between devel-
oped and developing countries is the extent to
which they are aware of it and the extent to
which they have the capability to act on that
awareness.
4.1 BEPS and AEOI—What Are the Issues?
The BEPS agenda has grown out of the
realisation that the aggregated impact of indi-
vidual domestic corporate tax regimes was
inadequate to deal with the increasing global
economic integration and the global integra-
tion of corporations. The global nature of
integrated supply chains and the growing
importance of services and digital products
that can be delivered over the internet breaks
the traditional physical link between busi-
nesses and their customers. Specifically,
corporations that operate in multiple jurisdic-
tions can transact business in one country.
If they then shift the profits to another,
lower taxing, country, the revenue base
of the first country is eroded. In response
to these challenges, the OECD has
developed an action plan to address BEPS
issues in a coordinated and comprehensive
manner.
Developing countries with weak revenue
administrations face major challenges from
BEPS—in many cases they will simply be
unaware of the revenue they are losing. That
said, with limited tax bases at their disposal,
developing countries can ill afford to have
their corporate tax base eroded.
Resource rich developing countries face an
interesting choice in the presence of BEPS by
resource companies in their country. They
could simply forgo the corporate revenue—
accepting that they do not have the adminis-
trative capacity to stop any profits being
transfer priced to a lower tax jurisdiction.
© 2015 The Author. Asia and the Pacific Policy Studies
180 Asia & the Pacific Policy Studies
Instead they could put all their eggs in the
royalty basket. They could acknowledge that
focusing on royalties may be a second best
option from a technical perspective, but that
from a practical perspective, it is their best
option.
AEOI is a key aspect in reducing tax
evasion. By facilitating the systematic trans-
mission across jurisdictions of taxpayer infor-
mation concerning various categories of
income, AEOI can provide timely information
on non-compliance where tax has been evaded,
even when tax administrations had no previous
indications of non-compliance.
4.2 Building Capability to Participate in the
BEPS and AEOI Agendas
To date, some developing countries have not
embraced the AEOI agenda. They have identi-
fied a number of concerns including over the
legislative and administrative changes required
to meet the global standard and the cost of
investing in hardware to collect, store and
encrypt the data. There are also concerns about
the extent to which developing countries have
the capacity to follow up on possible requests
by other jurisdictions for additional informa-
tion on their citizens. More generally, there are
concerns about whether meeting the global
standard for AEOI will draw resources away
from other priority areas of tax administration.
The concerns from developing countries
around BEPS and AEOI are well founded if
taking forward relevant aspects of the BEPS
action plan and meeting the requirements for
AEOI are seen as substitutes for other activi-
ties to strengthen revenue administration. The
particular risk is if countries enact legislation
around either BEPS or AEOI, without the
capability to implement that legislation.
The focus needs to be an orderly and
sequenced set of interventions that look to put
in place the building blocks of an effective tax
administration. As the capability and the com-
petency of the administration improve, then
the government can consider more sophisti-
cated and more efficient taxes, including taxes
that address BEPS and AEOI.
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January 2015
To enact and then enforce the legislation and
agreements identified under the BEPS action
plan will require competency across the range
of tax administration functions. Developing
countries may want to adopt rules to address
transfer pricing by limiting the movement of
intangibles among group members. But for
these rules to have effect requires basic things
like effectively registering taxpayers, having
them comply with their declaration and lodge-
ment obligations and then effectively collect-
ing the taxes that these taxpayers owe. As
discussed in Section 2, some developing
countries need to focus on these building
blocks.
Similarly, to meet the confidentiality and
data management practises to comply with
AEOI obligations will be a stretch for some
jurisdictions. However, an effective tax admin-
istration does have the capability to keep tax-
payer records confidential, and to record and
maintain databases of taxpayer information.
Building the capability to meet the basic com-
petencies that a revenue administration needs
will also support these administrations partici-
pating in the AEOI program.
The ability to actively participate and
benefit from the global work on BEPS and
AEOI is a credible and achievable aspiration
for developing countries. However, it needs to
be situated in the reality of where they are and
have a time-bound roadmap associated with it.
The new TADAT framework could provide a
good foundation to support the development of
such a roadmap.
The availability of resources to support this
development is often cited as a constraint. In
practice, there are three potential constraints:
the availability of funds; the domestic political
will; and the actual speed with which capabil-
ity can be built (that is how long it takes to
train people; or to roll out new systems, or to
educate taxpayers). At different times, each of
these constraints will be binding.
5. Political Economy Challenges Are
Common across All Jurisdictions
The tax system is the most direct and visible
instrument that the state has to reallocate
© 2015 The Author. Asia and the Pacific Policy Studies
 Carnahan: Taxation Challenges in Developing Countries
wealth within a society. Regulatory instru-
ments or licensing decisions may reallocate
significantly greater wealth, but the tax system
is the most obvious. Accordingly, changes in
the tax system are invariably difficult, vexed
and highly contested. This is true for both tax
policy changes, which are relatively simple to
implement, and tax administration changes,
which take longer to implement.
Tax changes involve winners and losers.
The only revenue neutral tax reform with no
losers is the status quo. The winners and
losers are very clear with changes to direct tax
bases. There may be some confusion with
changes to indirect tax bases that alter relative
prices. In general, this confusion leads to an
overstating of losses, and an understating of
gains.11
Tax changes are often introduced to improve
the efficiency of the tax system. That is, under
the new tax system the costs (administrative,
compliance and economic) of raising revenue
will be lower. This may be the case in the
medium to longer term. However, in the short
term, there will be upfront administrative and
compliance costs associated with shifting to a
new regime. The dynamic gains associated
with the reallocation of factors of production
or goods and services to higher valued uses
also occurs over time—and is viewed scepti-
cally by non-economists.
These elements mean that changing the tax
system is always an exercise in both econom-
ics (what is technically feasible and efficient)
and politics or governance (what is politically
feasible). This is the certainly the case in
developed countries. The introduction of a
goods and services tax (GST) into Australia is
a case in point.
In 1972, the Liberal government of Sir
William McMahon established a Taxation
Review Committee chaired by Sir Kenneth
Asprey to conduct a full-scale inquiry into the
taxation system. It commenced in September
1972 and presented its final report in January
1975. After two major forays into the public
11. The concept of loss aversion, overstating losses and
understating gains is generally attributed to Kahneman and
Tversky (1984).
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181
debate in 1985 and the early 1990s, the GST
legislation was passed in 1999 and came into
effect in 2000. Some of the Asprey Committee
recommendations on direct taxes were acted
on more rapidly—being introduced just a
decade after the report was finalised.
In developing countries, the political
economy elements of tax reform may present
an even greater challenge. There is often the
same level of vexation and contest around
major policy changes. However, the political
and civil society apparatus that can facilitate
and moderate public debate in developed
countries may not be as well developed. This
means that introducing reforms may be even
more problematic.
In supporting taxation reforms in develop-
ing countries, international organisations and
donor countries need to remain mindful of
the importance of understanding the local
political context. As the OECD (2009)
notes: ‘Political commitment to reform is
crucial, and more important than the formal
status of revenue authorities. Experience
underlines the importance of local leadership,
locally developed solutions and donor sensi-
tivity to local political and social context’.
Similarly Cottarelli (2011) concludes: ‘Sus-
tained political commitment from the highest
level is essential for deep reform, which
needs then to be entrenched to prevent
backsliding’.
The likely slow pace of reforms means that
partners need to engage for the long term.
Building stronger revenue systems with good
policies is an investment that will take
decades. Successes sometimes come in years,
but never in months. So supporting reform
to policies or administration needs to focus on
a long-term structured engagement. Strong
institutional partnerships that can endure over
time are the key to successful support. These
will be complemented by strong individual
relationships—but individual relationships can
never be a successful substitute.
6. Conclusion
The ability to raise revenue to fund the basic
public goods is central to what it means to be a
© 2015 The Author. Asia and the Pacific Policy Studies
182 Asia & the Pacific Policy Studies
sovereign state. And the actual raising of that
revenue is seen to play an increasing role in
establishing and reinforcing the legitimacy of
the state.
Building capacity and capability takes
time—in the short to medium term—it makes
sense to treat administrative capacity as rela-
tively fixed. So countries with weak revenue
administrations have a range of choices over
how they allocate their scarce administrative
capability across tax bases and over the choice
of taxes within those bases.
However, in the medium to longer term,
well-designed capacity development pro-
grams can make a real contribution to the
quality and effectiveness of a revenue admin-
istration. In this context, a well-designed
and effectively sequenced program will see
countries build their capacity and capability.
The ability to enact the BEPS and AEOI
agendas will be a consequence of their stron-
ger administrations, not a goal in and of
themselves.
Finally, questions have been raised around
the funds available to support building
this revenue administration capability. That
issue is beyond the scope of this article.
Building a functioning administration is a
step-by-step process with few shortcuts. In
this regard, the funding question will deter-
mine how long the process will take,
rather than what should be included in the
process.
January 2015
The author would like to thank Shane Evans,
Hien Tran, Cate Rogers, Christian Downie and
Kerstin Wijeyewardene for helpful comments on
earlier drafts. The usual caveats apply. The views
expressed in the article are those of the author
and do not necessarily reflect the views of the
Government, the Minister for Foreign Affairs and
Trade, or of the Department or Foreign Affairs and
Trade.
published by Crawford School of Public Policy at The Australian National University and Wiley Publishing Asia Pty Ltd
January 2015
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© 2015 The Author. Asia and the Pacific Policy Studies