Building Tax Capacity in Developing Countries

Abstract

Executive Summary Building tax capacity-the policy, institutions, and technical capabilities to collect tax revenue-is central to the role of government in development. The COVID-19 pandemic, the global energy crisis, and Russia's war in Ukraine have served as reminders that economic resilience rests in no small part on domestic public revenue levers and the ability to fund suitable policy responses. Tax capacity is also integral to achieving the Sustainable Development Goals (SDGs), addressing climate change, and ensuring debt sustainability. Estimates suggest that additional average annual spending of up to 16 percent of GDP is needed in low-income developing countries (LIDCs) to reach the SDGs by 2030. Despite progress, there is a large unmet tax potential in LIDCs. Tax revenue has progressed in LIDCs, with the average tax-to-GDP ratios increasing by about 3.5 percentage points since the early 1990s, to 13.8 percent in 2020. Country experiences vary, and the sustainability of revenue gains remains fragile in the face of shocks. New empirical evidence in this paper suggests that significant further increase is possible. Achieving this goal will require firm commitment to building better institutions that govern the tax system and manage tax system reform and improving the design of core taxes. This note provides practical lessons and guidance on how to improve tax capacity, with emphasis on LIDCs, building on IMF staff members' hands-on experience and empirical work. Key findings include: • LIDCs can raise their tax-to-GDP ratio by, on average, 6.7 percentage points to achieve their full potential, given current institutions and economic structures. Institutional reform, by bringing them to the level of emerging market economies (EMEs), can raise an additional 2.3 points. The total-9 percentage points of GDP-would go a long way toward enabling the state to play its role more fully in sustainable, inclusive, and resilient development. • This revenue increase requires strengthening the design of core taxes-VAT and excises and personal and corporate income taxes. The focus should be on tax base broadening through reforming ineffective tax expenditures, more neutral taxation of capital income, and better use of real property taxes-thus accounting for both efficiency and equity considerations. • Improvement in institutions that govern the tax system and manage tax reform is key to yielding results. It calls for adequate tax policy units to forecast and analyze the impact of tax policies across all economic policy dimensions, greater professionalization of public officials working on tax design and implementation, better use of digital technologies to strengthen revenue administrations, and transparency and certainty in how policy and administration are translated into legislation. • Tax capacity must continue to rest primarily on improving the design and administration of the core domestic taxes. Ongoing international cooperation on the taxation of the profits of multinational enterprises (MNEs), though important, is insufficient to meet revenue mobilization needs of LIDCs and should not distract from pursuing the wider objective of building tax capacity for development.