In Revenue Reform and Statebuilding in Anglophone Africa by Mick Moore May 2013 ICTD Working Paper 10 referenced and annexed in the posting on the PFMBoard “Irishman has recipe for increasing tax revenue”
http://pfmboard.com/the revenue framework, a focus of much of the excellent paper’s discussion has been on the failure to continue with growth in the revenue to GDP ratio once the Autonomous Revenue Agencies have been established. However, the paper overlooks a critical aspect of revenue generation and the measure of GDP, in this regard.
Tax to GDP ratios differ quite dramatically often between countries with at what looks at first sight similar tax structures. Often this difference is ascribed to tax policy (including the scope and extent of exemptions as Mike Moore’s paper acknowledges) and tax administration, while not fully looking at the main tax driver, the economy itself. Indeed good tax policy and good tax administration should not distinguish between sectors in an economy with respect to how they are taxed. Perhaps, then the most logical explanation of this is the observation that these higher tax-to-GDP-ratio countries have a higher share of monetised economy in GDP through formal activity in industry, agriculture and tourism. Money means spending on taxed goods. Earning money leads to payment of direct taxes. Increased income means spending on excisable goods. The issue is not necessarily the composition of GDP but understanding how GDP is estimated.
Over the years I have modelled this hypothesis in work on revenue forecasting in Uganda, Rwanda and Tanzania and more recently in Albania. In Albania this was done in two time periods which has allowed observation on the evolution of the estimation of GDP. The construction of Albania’s GDP is made up two main elements: the observed value added and the non observed value added. In addition, agriculture has an own consumption element in its construction. It can be assumed that non observed value added is what could be termed the informal sector and own consumption the non monetised sector. The observed sectors is the formal sector. The relative sizes of each of these elements will impact on the Albania’s tax base relative to GDP. Estimating GDP by value added by sector in 2010, 39% of agriculture value added is not sold i.e. is not monetised and 17.5% of value added in all sectors minus public administration is generated using the non observed technique. In 2004, comparable figures were 44% and 29%. This would suggest that in 2010, 7.9% of GDP by sector value added is non monetised, 13.7% is informal, 64.5% is formal with a further 14% in public administration. In 2004 the comparable figures were 11% of GDP is non monetised, 23% is informal, 58% is formal and 9% in public administration. This indicates that Albania’s tax base has expanded though still has room to grow further.
This construction is useful in an attempt to explain and forecast revenue, as the contribution of the formal monetised sector to the tax revenue is likely to be higher than the informal sector’s. The informal sector is unlikely to be registered for VAT so its value added will not be taxed (its inputs, however, are likely to be, if purchased from the formal sector). The surplus of the informal sector may be taxed through presumptive taxes if the authorities have been able to register the entities, whereas formal sector companies will be taxed on their profits. Formal sector companies' employees will be subject to PAYE, while informal entities will not. The non monetised element of GDP will be outside the tax base completely.
How the composition of GDP changes can have an impact on revenue without any changes in tax policy and tax administration, though in reality improvements in the latter two may well influence the structure of GDP thought improving incentives and compliance. Since 2007 Albania has embarked on tax policy and tax administration reform that will have improved the incentive structure and these will have yielded some improvements in the tax to GDP ratio. Tax reform is seen as a spur to investment to generate the growth needed for structural change. However, significant improvements in the tax to GDP ratio will only be realised when the monetised formal economy has a significantly higher share of GDP than it presently has. Indeed since 2007, tax to GDP ratios have remained relatively constant while nominal tax rates have decreased for many taxes which suggests that the improved tax administration and higher share of monetised and formal activity in GDP has compensated for the impact of lower rates.
It is possible to formulate a simple model based on the tax to GDP relationships and the structure of GDP to show what would happen to the tax to GDP ratio given changes in the structure of the economy. Three basic relationships are modelled.
• GDP grows annually - the various sectoral components can grow at a uniform rate or by different amounts.
• With developments in the economy, there is a graduation from the non-monetised sector to the informal sector, and from the informal sector to the formal sector.
• As the size of the formal sector grows relative to the informal sector and the informal sector grows relative to the non-monetised, there is a greater contribution to tax per unit of GDP.
Sizable increases in revenue to GDP ratios from one year to another will only happen if the composition – the structure - of GDP changes in the manner addressed here.
