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Asian Development Outlook (ADO) 2022 Theme Chapter, Mobilizing Taxes for Development

Summary

  • Asia must mobilize taxes and expenditure for sustainable development.

    Achieving the Sustainable Development Goals (SDGs) for a greener and more inclusive future requires vast public spending. While more efficient spending can free up some fiscal resources, much greater resources are needed to promote inclusive development in earnest. Tax revenue was gradually rising in the region before the COVID-19 pandemic but was still comparatively low. Restoring fiscal sustainability after COVID-19 adds to the urgency of making all forms of fiscal resource mobilization more effective, especially taxes.

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  • The region needs to augment fiscal space through higher tax revenue.

    Estimates that benchmark current tax revenue against key economic characteristics suggest that economies in developing Asia could increase tax revenue from a pre-pandemic average equal to about 16% of GDP by, on average, 3–4 percentage points. Options to strengthen revenue depend on economy-specific circumstances, but two priorities with broad promise are better optimization of tax expenditures—forgone taxes—and more efficient collection of value-added tax (VAT), including appropriate taxes on the fast-growing digital economy. In addition, strengthening personal income and property taxes can raise additional revenue and make tax systems more progressive.

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  • Green and health taxes contribute to both revenue and development goals.

    Environmental tax instruments continue to grow and positively guide investment and consumption in developing Asia. Some regional governments have long experience in levying environmental taxes, notably on pollutants and fossil fuels. More recently, Asian economies have actively explored carbon pricing instruments to curb emissions. The region can draw valuable lessons from early adopters, especially by ensuring sufficiently high tax rates and pollution prices and effective monitoring, reporting, and verification systems. Higher corrective health taxes, primarily on alcohol and tobacco, can raise additional tax revenue by as much as 0.6% of GDP while improving health outcomes and cutting medical costs.

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  • Tax and other reform to lift revenue is hard but doable.

    New analysis finds that reducing business registration costs can expand the share of the formal sector in the whole economy and the taxes it pays. Tax reform to boost revenue may be politically challenging, but global experience shows that strong leadership can enable success. Effective strategies strengthen tax administration, including through better use of information and communication technology, and improve taxpayer morale by, for example, improving the quality of public spending.

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Taxes must be mobilized to support sustainable development

Resuming the region’s stellar economic progress will entail vast expenditure.

Resuming the region’s stellar economic progress will entail vast expenditure.

Developing Asia’s traditional fiscal prudence, characterized by small government and low debt, has well served the regional goals of poverty elimination and higher living standards.

However, it is now under pressure. The COVID-19 pandemic has set back development progress and highlighted weaknesses in government finances. To ensure that inclusive and sustainable development resumes and that the SDGs are achieved, spending needs to be ramped up in the key areas of health care, education, infrastructure, and social protection, as well as in climate change adaptation and mitigation.

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Taxes need to be mobilized to meet regional expenditure needs.

Taxes need to be mobilized to meet regional expenditure needs.

While private finance has an important role to play, much of the required spending will need to come from government.

Taxes are the main government revenue source, with higher-tax economies tending to spend more on education, health care, and social protection. While gradually rising before the COVID-19 pandemic in tandem with rapid development, tax revenue in developing Asia remained low, even relative to a developing economy peer such as Latin America. Accounting for about half of all tax revenue, consumption taxes, notably VAT, are revenue mainstays in the region, supported by robust corporate tax receipts. Personal income tax revenue accounts for a small share by comparison. This tax mix is efficient but less progressive than in high-income economies and therefore less inclusive.

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The COVID-19 pandemic hit public finances hard.

The COVID-19 pandemic hit public finances hard.

Tax stimulus was widely used to support households and businesses even as tax receipts plunged under an unprecedented economic downturn.

This substantially expanded fiscal deficits and debt. While deficits are starting to narrow again, additional careful fiscal consolidation will be needed in many economies to safeguard fiscal sustainability. Given structurally low spending and continued pressure in such important areas as education and health care, governments should strive to improve spending efficiency and wind back tax and other stimulus measures in a timely way. Further, they should carefully consider options to increase tax revenue, especially in economies where it is very low.

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Priorities for mobilizing tax revenue depend on economy-specific circumstances

Priorities for mobilizing tax revenue depend on economy-specific circumstances

Newly formulated tax capacity estimates, which benchmark revenue against key economic features, indicate that economies in developing Asia could increase tax revenue from a pre-pandemic average of about 16% of GDP by, on average, 3–4 percentage points. However, this potential varies within the region and is generally higher in Southeast Asia, where revenue is often lowest.

Tax expenditures—or tax not collected—are widely used in the region, including to support households and businesses hard hit by the pandemic. Some tax expenditures lack any clear policy justification, however, while significantly reducing revenue. Government reporting of tax expenditures is often lax, but estimates suggest that on average they curtail tax revenue in the region by about 14%. Tax incentives to lure businesses are often ineffective and can undermine healthy competition. Governments should weigh costs and benefits and consider ways to promote investment that are less expensive and more effective. Meanwhile, most governments need to improve tax expenditure transparency and regularly report costs.

Low tax efficiency and comparatively low tax rates indicate that potential exists to increase VAT revenue in some economies. Tax authorities need to ensure appropriate taxation of imported digital products to ensure that online commerce does not erode VAT revenue. Increasing personal income tax revenue is a challenge, especially where collection capacity is weak, and it may undermine work incentives. However, personal income tax can make tax systems more progressive and thus societies more equitable. More revenue can be raised as well from property taxes, which can bolster local government finances and are readily efficient and progressive.

The two-pillar solution developed under the Inclusive Framework on Base Erosion and Profit Shifting enables economies to share corporate income taxing rights, and it proposes a global minimum tax rate. This initiative is welcome, but few economies in developing Asia will likely see significant revenue impact in the near term. The economies that stand to benefit most from reallocated taxing rights are likely to be resource exporters and those with large domestic markets. Investment hubs may lose revenue. Similarly, the revenue impact of introducing a 15% global minimum corporate income tax rate is likely to be small in developing Asia, as most economies in the region already meet it.

Green and health taxes strengthen revenue and development

Tax instruments for the environment have begun to realize their promise.

Tax instruments for the environment have begun to realize their promise.

In some Asian economies, fiscal instruments such as pollutant and fossil fuel taxes, most notably on gasoline and coal, are long established and help to reduce pollution, guide energy consumption, and generate revenue.

Recently, some economies in developing Asia have introduced carbon pricing instruments to combat climate change, with Kazakhstan, the People’s Republic of China, and the Republic of Korea implementing national schemes for trading emissions. Singapore and Indonesia have introduced a carbon tax. As carbon prices and tax rates are low, and implementation gradual, revenue from these instruments remains modest but has potential to grow and reduce air pollution and carbon emissions.

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Environmental tax instruments must be well designed and implemented.

Environmental tax instruments must be well designed and implemented.

Effective carbon pricing and environmental taxes require sound instrument design and careful implementation that features reliable monitoring, reporting, and verification systems.

Carbon prices and environmental taxes must be significant to be effective. Gradual implementation addresses competitiveness concerns but reduces revenue generation and alignment with environmental goals. Revenue transfers such as rebates and subsidies can encourage innovation and cushion adverse effects on vulnerable groups. Earmarking can facilitate public acceptance and implementation. Consistent application of carbon pricing across economies and regions would amplify their benefits and minimize costs.

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Corrective health taxes both raise revenue and improve public well-being.

Corrective health taxes both raise revenue and improve public well-being.

Lifestyle diseases exact heavy costs on health and wealth in developing Asia. Led by tobacco, alcohol, and unhealthy diets, they cause 77% of all deaths in the region.

Associated productivity loss is estimated to equal 2% of GDP. Corrective health taxes can be powerful tools to reduce harmful consumption. Tax design and implementation should consider demand responses, distributional consequences, and how to use the tax revenue thus collected, including through earmarks. Regionally, corrective health tax revenue still falls below associated costs incurred for medical treatment and from productivity lost to death and disability. Higher corrective health taxes could raise additional revenue by as much as an estimated 0.6% of GDP, while improving health outcomes and cutting medical costs.

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Reform to reduce informality and lift tax revenue is hard but doable

Reform to reduce informality and lift tax revenue is hard but doable

Generally relaxed regulatory barriers and low tax burdens in the region have helped keep unemployment low and growth rapid. However, the high cost of business registration is an exception, which partly explains the region’s large informal sector. Policy simulations using a simple two-sector model, both formal and informal, indicate that lower registration costs are particularly effective at reducing informality and increasing tax revenue, productivity, and wages. Stronger enforcement of existing laws and regulations can also reduce informality and increase tax revenue.

Governments often attempt tax reform but then fail, leaving them stuck with low revenue. However, experience from around the world demonstrates that it is possible to implement policies that lift tax revenue by the equivalent of several percentage points of GDP or more. Successful tax reform requires strong leadership with clearly articulated priorities toward feasible policies. Also helpful is a reform road map supported by international cooperation and technical assistance. As major crises sometimes pave the way for tax reform, the current period of pandemic recovery may be an opportune time to embark on ambitious tax reform.

While the impositions of tax compliance have eased across the region, they remain substantial in some economies. Tax administrators can harness technology more effectively to reduce their own administrative costs, improve access to information, and so facilitate compliance. Organizational reform to improve utilization of scarce resources, enhance administrative autonomy, and incentivize performance promises to strengthen tax administration. Tax reform is best accompanied by efforts to strengthen the social contract and tap intrinsic willingness to pay taxes, most notably by improving the quality of government spending. Empirical evidence informed by behavioral insights suggests that significant opportunities exist for governments to experimentally apply sticks as well as carrots, including deterrence messages.