TAX POLICY AND ECONOMIC GROWTH IN DEVELOPING NATIONS

BY

ALVIN RABUSHKA

STANFORD UNIVERSITY

AND

BRUCE BARTLETT

HERITAGE FOUNDATION

PREPARED FOR:
PPC/EA AGENCY FOR INTERNATIONAL DEVELOPMENT

WASHINGTON, D.C. 20523

UNDER CONTRACT:
PDC-0092-I-04-4045-00 WIork Order No. 04, November 1985
 TABLE OF CONTENTS

Preface Page

List of Tables

List of Figures
Chapter I. Introduction
1
Chapter II. Explicit Taxes 9
Chapter III. Implicit Taxes 37
Chapter IV. Taxation, Economic Growth, 58
and Democracy
Chapter V. Successful rax Incentives 129
Plots of Marginal Tax Rates
136
Additional References
157
Summary of Comments by Experts,
161
USAID Conference on Tax Policy and
Economic Growth
 PREFACE

At an October 1985 IMF/World Bank meeting

in Seoul, Korea,
Treasury Secretary James A. Baker,
III, outlined a new U.S. ap­
proach to the the question of improving
the economies of tne Less
Developed Countries (LDCs). In essence, the plan calls for using

the World Bank to achieve economic growth

in the LDCs by encou­
raging the adoption of market-oriented
policies. Those countries
that adopt market-oriented, pro-growth
policies would be rewarded
by receiving additional loans and aid both from the World Bank

and private lenders.

Baker's approach to economic stagnation

in LDCs grows
from the Reagan Administration's belief
that many developing
countries will remain ensnared in the
poverty trap unless old
pilicies givp way to a pro-growth mix of new measures. Secretary
Baker outlined the following reforms
which would be necessary to

overcome economic stagnation in LDCs:

1. Increased reliance nn the private sector,

and less
reliance on government, to help increase employment, production

and efficiency.

2. Supply-side actions to mobilize domestic

savings and
facilitate efficient investment, both
domestic and foreign, by
means of tax reform, labor market reform
and development of

financial markets.

3. Market-opening measures to encourage

foreign direct
investment and capital inflows, as well as to liberalize trade,

i
including the reduction of export subsidies.

These policy recommendations are consistent with the

findings of this report. A careful analysis of explicit and

implicit taxes in up to 100 developing nations in Africa,

Latin Ame-ica, the Mediterranean, the Caribbean, and Asia

suggests a set of measures that policymakers in LDCs can employ

to stimulate growth.

First, high marginal tax rates should be sharply reduced,

especially on personal incomes. Second, threshhold levels at

which high marginal rates take effect should be increased.

Third, fiscal policy should encourage savings and investment.

Fourth, the ragtag mix of controls, regulations, parastatals,

tariffs, and other interventions in the economy that distort the

efficient allocation of resources--implicit taxes--should be

eliminated or neutralized. Those implicit taxes that require

serious attention include below-market, compulsory procurement of

agricultural products and other commodities (to increase aftertax

rates of return to producers), exchange rate restrictions and the

elimination of overvalued currencies, elimination of capital

controls, movement towards freer trade and international direct

investment, repeal of minimum wage legislation and other imped­

iments to the free movement and efficient utilization of labor,

elimination of costly business regulations, and curtailing

the devastating effect of inflation on holders of financial

assets.

It may not be possible in every developing country to

ii
 undertake a comprehensive overhaul
of economic policy, but
individual tax reforms that can be
carried out on a piecemeal

basis need not await the complete

transformation of economic
policy. The simple reduction of counterproductive
marginal tax
rates exceeding 50 percent would,
by itself, have a beneficial

effect, even in the absence of other policy changes.

We would like to thank a number of

people who have assisted
us in the preparation of this report.
First, we thank those
experts on development who attended
the A.I.D. Conference on
Taxation and Development held in Washington,
D.C., October 2-3,
1935. The participants included Stuert Butler
of the Heritage
Foundation, Vito Tanzi and Ved Gandhi
of the International
Monetary Fund, Seraldo Sicat of the
World Bank, Richard M. Bird
of the University of Toronto, Gary Robbins
of the Center for
Strategic and International Studies, Richard Goode of the
Brookings Institution, Oliver Oldman
of the Harvard Law School,

Howard Pack of Swarthmore College,

Sidney Weintraub of the
University of Texas at Austin, Gustav
Papanek of Boston Univer­
sity, and Arnold Harberger of the University
of Chicago.
We
appreciate the prepared comments of
these scholars, though we do
not necessarily agree with all of them. However, this final

draft incorporates a number of their-

comments.
At the Agency for International Development we thank our
project officer, Neal Riden, our conference moderator, Ed

Hullander, and for his insights, Kenneth

Kauffman. Others at

iii
A.I.D. who shared their views with
us include Rick Tropp, Richard

Durham, and M. Peter McPherson.

We appreciate the time that
Senator Dennis DeConcini and Representative
Jack F.. Kemp took
from their busy schedules to attend
a portion of our conference
to share their views on taxation
and development. Keene, Monk
and Associates provided excellent
support throughout the project
and we thank Peter Monk for his
technical assistance, Julia
Coppinger, Vinnie Carney, Hank Raullerson,
and Bill Guttman for
their cssistance with the conference
and general administrative
support. Finally, we thank Polly Butterfield
who prepared the
graphics that accompanied this report.

Finally, as is always the case in

a co-authored report, all
errors of fact or interpretation
are the fault of the other guy.

iv
 LIST OF TABLES

Chapter II
Page
Table 1. Individual Income Tax Rates in
21
West Germany

Chapter III
Table 1. Border Price and Domestic Price
for 38
Major Commodities in Jamaica,
1979
Table 2. Border Price and Domestic Price
for 39
Major Commodities in Columbia,
1979
Table 3. Distortions in Labor Costs and
Growth 41
Performance
Table 4. Capital Flight and Gross Capital
Inflows 44
in Selected Countries, 1979-82

Table 5. Inflation and Growth Performance

in 51
Selected Developing Countries

Chapter IV

Legend of Variables Used in the

Analyses 101
Significant Bivariate Relationships
102
Table 1. Crosstabulation of Economic Growth
by 108
Political Rights Index
Table 2. Crosstabulation of Economic Growth
by 109
Civil Rights Index
Taole . Crosstabulation of Per Capita
GNP 110
by Political Rights Index
Table 4. Crosstabulation of Per Capita
GNP 111
by Civil Rights Index
Table 5. Regression of Growth with Investment 112
and Direct Taxation
Table 6. Current Marginal Tax Rates and
Average 113
Annual Economic Growth in LDCs,
1960-82
 Page
Table 7. Regression of Export Growth with
115
Industrial Growth Rate, 1960-82
Table 8. Regression of Import Growth with
116
Investment Growth Rate and Export
Growth Rate, 1960-82

Table 9. Regression of Government Expenditure

117
with Taxation as Percentage of GNP,
1960-82

Table 10. Regression of External Public Debt 118

with Growth, 1960-82

Table 11. Regression of Private Consumption Growth

119
with Growth, 1960-82

Table 12. Crosstabulation of Political System with 120

Political Righto Index

Table 13. Crosstabulation of Political

System with 121
Civil Rights Index

Table 14. Crosstabulation of Political System with 122

Growth

Table 15. Crosstabulation of Political System with

12.
Per Capita GNP
International Monetary Fund List of Tax
and 124

Nontax Revenue

List of Developing Countries in Analysis

File 126
 LIST OF FIGURES
Page

104
of GNP with
Taxes as percentage 105
Figure 1- G owth

Figure • Growth with Direct TaxatiOn 106

Figure *. Growth of Imports With indirect 106

Taxation 107
indirect Taxation
Growth with
Figure 4.
 CHAPTER I

INTRODUCTION

A basic premise of this study is that

the impact of tax
rates---especially marginal tax rates--has
been largely ignored,
or at least underemphasized, in the
traditional development
literature. Why is this? In a paper prepared for a conference

sponsored by the Agency for International Development iii Oictober

1985, Vito Tanzi of the International Monetary Fund answers

as

follows:

"First, there has been the traditional

view that, in
developing countries, high incomes do
not originate from work
effort or entrepreneurship; they are assumed to reflect mostly
inherited wealth. Thus, they are more in the nature of rents
than of genuine incomes. As a consequence, they could be taxed

away with little negative effects. Second, that high incomes

inevitably result in high consumption
and/or capital flight.
Third, that in any case the government can generate
a high rate
of sa-.ing for the country by raising taxes
while holding down
its own consumption. In this way, whatever negative effect
high
marginal tax rates might have on the individuals'
propensity to
save could be more than compensated by
higher govern,_2nt saving.
Fourth, because of lack of knowhow and entrepreneurship in the
private sector, the government had to
take the initiative in
carrying out investment. The government was seen as the engine

of growth in the economy. Fifth, the negative effect on labor

1
 supply could be ignored because of the
overabundance of labor.
Some influential studies assumed that the supply of labor
schedule was perrfectly elastic at a subsistance
level of wages.
Sixth, that private investment in desirable
sectors could be
stimulated through the use of specific
tax incentives, so that
low tax rates on corporate income were
not necessary. Seventh,
that in any case there was little solid
evidence that marginal
tax rates were important in determining
the propensity to save,

invest, or to supply greater effort."

Although these assumptions were clearly

not shared by all
development economists, Tanzi notes that many of them were
prevalent throughout much of the literature
on economic develop­
ment and taxation until recent years. How did they prove

faulty? According to Tanzi:

"First, in developing countries, large incomes are often

more the result of... implicit taxes, than
of property ownership.
In many developing societies toddy it
is more important to have

access to subsidized credit, to scarce

foreign exchange at
official exchange rates, to import licenses, or
to be able to
produce behind a protective wall than to own property. The
return to property ownership in the form
of rents, profits,
interests, etc., is often sharply reduced by price controls,

regulations, and other similar policies

so that property owner­
ship is no guarantee of large incomes. Rents based on government
policies have replaced rents based on
property ownership.

"Second, the assumption that high income

inevitably results

2
 in high consumption has been challr.,ged
in various theories of
the consumption funLtion. Some of these challenges are
as
relevant for developing countries
as they are for industrial

countries.
"Third, with the benefit of insight, it is easy to show that
governments have been unable
to resist pressures for higher
public consumption, or for politically
determined investment
projects. Thus, in many countries the increase in the tax burden
that took place over the years
did not resul t in higher public
saving, as had been anticipated,
but in higher public consump­
tion. Furthermore, whatever public investment
did take place, it
was often misallocated resulting
in very low or negative rates
of
return.

"Fourth, it has become obvious

that the governr. nt does not
have a monopoly over knowhow
or entrepreneurship. A country
"ithout 2ntrepreneurs in the private sector
is not going to
produce them in the public sector.
And, by the same toten,
Adam
Smith's basic contention that
when people do things for them­
selves they become more productive
and more enterprising has
been recognized to be valid in
many countries today, including
in
a more glaring fashion in some
centrally planned economies.
"Fifth, it has been recognized
that even though the overall
labor supply may be abundant,
as evidenced by the existence
of a
high rate of unemployment, it
is rarely abundant for particular
skills. Trained workers are as scarce
in labor abundant econo­
mies as they are in economies with overall labor scarcity.
 "Sixth, the argument on whether one can stimulate
more
investment by low corporate tax rates or by
investment incentives
is still a debatable one. Even within the United States today

there are well-known economists who are arguing

that the reform
proposed by the administration will discourage investment as it

will trade some investment incentives for lower

rates....
"Finally, while in the past it was often argued
that there
was no evidence that high marginal tax rates had any effects on

the propensity to save, invest, and work harder,

in recent years
more and more studies using sophisticated
techniques, have shown
that taxation ray in fact have some negative
effects."
Despite the transformation in thinking which
Tanzi describes
that has taken place during the past several
decades, the old
views still influence many scholars of development and decision­

makers in the developing world. It is common to find countries

with marginal income tax rates of 70, 80 or 90 percent applied at

relatively low incomes (by industrialized nation standards,.

Even though these top thresholds may represent

several multiples
of per capita gross domestic product in LDCs,
multiples of per
capita GDP are not the primary determinant
of incentives to work,
save, or invest, the factors that drive growth. Individuals
with entrepreneurial talent, specialized skili,
or capital are
aware of the better opportunities that exist for them
in other
countries. It is critical for developing nations to retain

talented people. The loss of this critical minority of pztential

entrepreneurs, scientists, engineers, professionals,
and skilled

4
 laborers ould grind the etCie
of-rsass
development to a
screecning halt. TnE, high marginal tax rates that affect a
Sma!- rinoritv of the population, and supply
less than one-tenth
of total
revenue, could have severe
repercussions out of all
proportion to the share of
the Population in the income
tax net
and the total amount of revenue
collected in individual taxes.
People and human capital
are no less internationally
tradeable and transferable
than commodities and capital.
In this
light, governments should
be more concerned to avoid
excessive
tax rates than current statutory
tables suggest.
The emphasis that marginal
tax rates receives in current
thinking about fiscal policy and incentives for
growth has come
under criticism by some students
of development. They contend
that even if marginal tax rates are important in
the development
process, the individual income tax is insignificant
compared with
the wide range of other government
policies that ditcourage
growth. In this paper we lable such
interferences "implicit
taxes" because the tax-like
effects of these government
interven­
tions in the private sector
can be analyzed within the
same
framework used to analyze
e.plicit statutory tax rates.
This is
because implicit taxes deny
people a rate of return on
work,
saving or investment that
is effectively equivalent
to a tax
levied on a market rate of
return.
Implicit to.,es are extremely
important; indeed, in many
LDCs, they overwhelm the
impact of the statutory tax
system on
levels of economic activity.
Accordingly, Chapter III
is

5
devoted entirely to analyzing the different kinds of implicit

taxes that afflict LDCs and their effects. However, It is a

mistake to ignore explicit taxes because they have negative

effects all their own, which are separate and distinct from

implicit tax effects. Moreover, implicit and explicit taxes tend

to go together in developing countries.

Good policies often come in consistent packages. The same

holds for bad policies. Nations with heavy government regulation

of the economy, misaligned exchange rates, price controls,

inflation, and other implicit taxes generally have bad explicit

tax systems as well. We know of no case, for example, where a

nation has a sensible package of economic policies marred solely

by a defective tax system. Nor do we know of any cases where a

nation with an exce).lent tax system imposes significant implicit

taxes on the economy.

In short, we believe that the tax system may be viewed as

something of a proxy for a range of oovernment policies. This is

useful because in many cases it is far easier to obtain data on

taxation than on the level of such other important governmental

interferences with the market as overvalued exchange rates,

4armgate prices and minimum wages, to name a few. There is, in

fact, almost no data on many of these important factors--at

least none which is publicly available to researchers. On the

other hand, statutory tax systems are available with diligent

research along with a wealth of data on aggregate levels of

taxation published by the IMF.

6
 The plan of this report is as follows:
Chapter II discusses the
impact of explicit taxation
on
development, taking into
account recent research on
the impact of
taxation on the economy and
applying, where possible,
to the
special conditions of the LDCs.
Chapter III explores the impact of what we call
implicit
taxes--government regulations,
controls and other interferences
with the free market that
reduce the rate of return
to work,
saving and investment.

Chapter IV examines the relationship

between tax structures
and tax rates with several
indicators of economic performance
and democratic institutions based on data
obtained from the World
Bank, the IMF, Freedom House, and commercial
tax services.
Chapter V enumerates a variety of
successful tax incentives
which have spurred investment,
output, and employment in
the
LDCs.

It has been our goal to accomplish

the followingg
To define the criteria with
which to evaluate tax systems,
using the concepts efficiency,
equity, and simplicity.
To set forth an empirical
illustration of an ideal
tax
system that meets the foregoing
criteria.
To assemble for the first
time a comprehensive data
file on
statutory marginal tax rates
in the LDCs. For some countries, we
have developed time series
data extending back to 1956.
To classify developing countries
by type of tax system,
level of taxation, and structure
of tax rates, including implicit

7
and explicit taxes.

To test the relationship between tax structure,

tax rates,
economic performance, and several measures of democratic institu­

tions including political freedoms and civil

liberties.
To analyze the relationship between tax policy and incen­
tives to see how tax policy either hampers or fosters economic

efficiency. From this we have drawn examples of successful tax

reforms and unproductive, inefficient tax
systems.
And lastly to list some specific individual
tax reforms that
have been successfully adopted in developing
countries.
We have accomplished these objectives within
a limited time
frame. Additional time would permit more thorough and comprehen­

sive data assembly and analysis. Nonetheless, this report

represents an important first step in a reassessment
of the role
of tax policy in economic development and lays a foundation for

future work that other researchers can continue.

Despite the
need for additional research, this study
stands on its own as a
significant attempt to catalogue and analyze
the tax systems of
the LDCs based on the most currently available
data in a way
which both policymakers and scholars in the
field will find of value.

8
 CHAPTER II

EXPLICIT TAXES

The development literature contains

relatively little on the
impact of taxation on growth. The main reason for this is the belief

that since such a small percentage

of residents of developing
countries participate in the money
economy or pay any taxes
whatsoever that the 9xplicit tax structure
is relatively
insignificant compared with a multitude
of other factors. Moreover,
the goal of fostering growth is generally far
down on the list of
priorities when designing a tax system.
Raising revenue is obviously
the overwhelming goal, but forced saving, income redistribution
and
administrative ease are also major
goals.
Until fairly recently, it was generally
believed that the major
function of the tax system was to
regulate aggregate demand, raise
taxes when excess demand stimulated
inflation and cut taxes to pump
up demand and stimulate growth.
Little, if any, attention was paid

to the structure of tax rates. Only aggregate levels mattered.

Hence, almost all previous research on the impact of
taxation on
developing countries has concentrated
on aggregate levels of taxation
as qshare of national output or on such questions as the
proportion
nue derived from various kinds of
taxes.[1]
As long as marginal rates remained relatively low on the
vast
bulk of the population, changes in the tax
structure didn't seem to
matter very much. However, when the inflation of the 1970s pushed
taxpayers in all industrialized countries up into tax
brackets
heretofore reserved for the wealthy,
many economists began to

9
 reexamine the microeconomic foundations of tax policy and attributed

the slow growth of the late 1970s to rising marginal tax rates.
Eventually the term "supply-side economics" came to be attached

to the view that reductions in marginal tax rates were a necessary

prerequisite to economic growth.[2] However, it really describes a

more fundamental change in the attitude towards taxation. Whereas

previously, taxes were thought to have little effect on the

rate of
saving[3], it is now widely believed that taxes have a significant

impact on the rate of saving.[4) Whereas previously, taxes were not

thought to have a significant impact on labor supply[5], taxes

are
now believed to have a significant impact on both the quantity
and
quality of work.[6] Whereas previously, there was little attention

paid to the economic limits of taxation, it is now recognized

that
because of such factors as the underground economy tax rates
may be
so high as to actually reduce government revenues.[7]

This thinking has yet to penetrate the development field, where

it is still common to read that a problem with developing countries

is an unwillingness to collect sufficient taxes, especially

from the

wealthy. For example:

Lord K'aldor: "The shortfall in revenue is...largely a reflection

of failure to tax the wealthier sectors of the community

effectively. "[8]

Richard Goode: "An underdeveloped country that is determined to

avoid both stagnation and inflation will have to find ways

of raising
large and growing amounts of tax revenue."[9]

Walter Heller: "A personal income tax with a narrow base but

high rates on large incomes, buttressed by administrative efforts

/0
 concentrated on this area, may be a suitable instrument
for achieving
some of the ends of economic policy and distributive
justice."[1O]
Barbara Ward: "One thing...is certain. No nation has even
halfway peacefully entered the modern world witiout
a progressive

income tax."[11]

W. Arthur Lewis: "If it is desired to accelerate capital

formation at a time when profits are still a small

proportion of
n;,tional income there is in practice no other way of doing
this than
to levy substantially upon agriculture.... "[12]

Substitution Effects

One important problem with the imposition of taxes

in a
developing country, as opposed to an industrialized
country, is that
the money economy competes with subsistence agriculture.
Since
direct taxes are seldm ever imposed except in the
money economy,
high taxes will tend to shift production out of the money economy
and
into subsistence agriculture.[13] "It is therefore likely,"
according to E:auer and Yamey, "that in many under-developed countries

taxation falling on activity in the money sector will

reduce thL
supply of effort to that sector below what it would
be otherwise.
This reallocation of resources affects adversely total
real income.
The lower national income and the retardation of the
spread of the
exchange economy in turn impede long-term growth."[14]

Bauer and Yamey also note the potentially adverse

effects of
trying ti increase national saving through taxation:

"The proceeds of compulsory saving are ;'ot a simple

addition to

11
 total saving. It is not even certain that total saving will be
increased in the process. Even when savings are increased in the

short run, the repercussions of the taxation may reduce the

flow of
savings in the long run by retarding the spread of the exchange

economy and the growth of specialization, though conversely,

it may
also be remembered that the expenditure of the funds may have

important beneficial effects promoting economic progress.... Whatever

the merits of such a transfer, they cannot be assessed rationally

unless it is recognized that it is a transfer and not a net

increase

of resources."[15]

Actually, it is more than likely that total saving will fall

sharply if the government attempts to raise saving by increasing

taxation. Rec-nt research indicates that this is because saving is

far more sensitive to after-tax rates of return than previously

thought. hence, the reduction in total n;.tional saving may exceed

the increase in government revenue. Even if taxes could be imposed

such that national saving would not suffer, the shift of resources

from the private to the public sector would still inhibit growth.
This is because, as Bauer and Yamey note, the restriction
of private
saving will restrict the supply and effectiveness of local

entrepreneurship and because the savings will be used to expand state

undertakings.[16]

Entrepreneurship, we know from recent research, is a critical

element in development.[17] High tax rates suppress entrepreneurship

more so than o?;er activities because entrepreneurs typically

undertake investments with greater risk. Hence they require an above

average rate of return. If this return is diminished too much by

 taxation, entrepreneurship
will dry up. As I.Keynes observed, "The
margin which he [the entrepreneur]
requires as his necessary
incentive to produce may be
a very small proportion of
the total
value of the product. But take this away from him
and the whole
process stops."[18)

This raises an important issue regarding the impact

of taxation
on development. Although a tax system may not
impact heavily on the
vast bulk of citizens -- and therefore appears insignificant
Ls a
factor in development -- it may impact particularly
on the
entrepreneurial class. This class includes those individuals
just
able to rise above subsistence
who may be trying to start
a new
business or who may be contemplating
additional education or training
to qualify them for the managerial
class. To such people -- who are
the economic "sparkplugs" of
society -- the marginal rate
of taxation
may be a significant factor
in their decision to start
a business,
obtain additional education,
or leave the country. Thus one cannot
assume that simply because
a tax is paid by few people
that it does
not influence their actions
and other potential taxpayers.
One reason for confusion on
this issue is a misunderstanding
about the relative importance
of the income and Substitution
effects
of taxation. The income effect suggests
that when taxation denies
people a portion of their income
they will increase their effort in
order to maintain the same
net ir.come. Thus, imposition of a tax may
stimulate, rather than retard,
work effort. The substitution effect,
on the other hand, determines
the trade-off between highly-taxed
activities and those which
may not be taxed or are taxed
at a lower
rate. Thus, there is a substitution
effect between work and leisure,

13
and savings and consumption, which may be strongly influenced
by the
tax rate. Consequently, there is always a tension between the income

and substitution effects which appears to make it difficult

to
determine whether imposition of a tax will stimulate or retard
effort. This is especially true in the case of some LDCs, where it

is assumed that there is already a predisposition toward leisure

and

consumption.

In fact, there is really no trade-off at all between the income

and substitution effects: the substitution effect always

predominates. This is due to the impact of relative price changes.

When a single price changes, whether due to a tax or some chanqe

in
supply or demand, it sets in motion two different effects:
It alters
the real income of those who wo'ild have purchased the product at its

old price and it stimulates them to search for alternatives.

Thus in
the case of any individual, it is true that one cannot, as a matter

of theory, determine whether the income effect or the substitution

effect will predominate.

This is not true for society, however, because as soon as one

expands the universe of analysis to include the seller, one

can see
that the income effects necessarily cancel out: The increased income
of the buyer is exactly offset by reduced income of the seller,
or
vice versa. Thus, the substitution effect will necessarily

predominate.

How likely is it that the income effects will cancel out

this way? Sir John Hicks answered as follows:

In equilibrium, supply equals demand; and therefore the initial

effect of a fall in price (before any adjustment in supply or

 demand is made) is to make buyers
better off and the sellers worse
off, by an exactly equal amount
.... Therefore, if buyers and
sellers
react to a change in income in
the same way, the increased demand
from the buyers (due to the
income effect) will be matched
by an
increased supply from the sellers
(due to the income effect). The
income effect on excess demand
will be nil.[19J
The same point is true of taxation.
If a tax deprives an
individual of income it is exactly offset by
the increase in income
of whomever rereives the government's
expenditures. This is
obviously true in the case of
a pure income transfer. But it is
really true of all government taxation. Hence, all that is left is
the extent to which the tax rate
influences substitution. This
includes the shift of work into
leisure or the untaxed sector
(such
as subsistence agriculture or
the underground economy) and
the
reduction of saving and investment
into consumption or capital

flight.

Taxation and Development in the

Industrialized Nations

This framework permits the tax

experience of the industrialized
countries to be applied to the
developing world. Some analysts
maintain that there is little
in the experience of the industrialized
countries which is applicable
to the developing nations. This
overlooks the important point
that the industrialized nations
were
not always industrialized. Prior to the Industrial Revolution,
England, the United States and
the European nations were in
a
position not too dissimilar to
many LDCs today. In addition, one

15
might say that the war damage inflicted by World War II destroyed the
industrial base of nations like Germany and Japan. For these
reasons, it it worth briefly examining the Industrial Revolution and

the postwar experience of G8rmany and Japan to see what role, if any,

tax policy may have played.

The Industrial Revolution began in England in the late 1700s.

There is still debate about its precise causes, but there is little

question that the intellectual climate of laissez-faire contributed

greatly in helping to rid the nation of stifling regulations, tariffs

and other barriers to economic expansion. As one economist put it,

"the laissez-faire ideology... blasted the ideological barriers and

institutional barriers to progress and welfare."[20]

The classical economists of that period were not opposed to

government per se, attributing an important role to it in protecting

property rights and providing necessary roads, harbors and other

public works. And they were as concerned about the stifling effect

of private monopolies in restraining growth as they were of

government.E21] Nevertheless, it is true that the classical

economists attributed little positive role to the state in

encouraging growth, other than in the dismantling of state barriers

to it.[22] As Adam Smith wrote:

It is the highest impertinence and presumption... in kings and

ministers, to pretend to watch over the economy of private

people, and to restrain their expence, either by sumptuary laws,

or by prohibiting the importation of foreign luxuries. They are

themselves always, and without exception, the greatest

spendthrifts in the society. Let them look well after their own
 expence, and they can safely trust
private people with theirs.[J23]
Classical economists shared thr view that people would
Invariably find ways of getting
around most state barriers to wealth
creation, if the state could be
restrained from extending its domain
into such new areas. "The natural effort of every individual
to
better his own condition...is so
powerful a principle," Smith wrote,
"that it is alone, and without assistance,
not only capable of
carrying on the society to wealth
and prosperity, but of surmounting
a hundred impertinent obstructions
with which the folly of human laws

too often incumbers its operations."[24]

The cotton industry is a case in

point. As an entirely new
industry, it was untouched by existing
laws and regulations. As Paul
Mantoux notes, by the very fact
of its novelty, any recently-created
industry was beyond government's
hold. And unless it became the
object of special laws or regulations it could, therefore,
grow up in
complete freedom.[25] Indeed, just keeping up with the
changes in a
rapidly expanding industry like
cotton was beyond government to

regulate. As Mantoux writes:

It was hard enough to maintain the

old regulations, and it was
becoming quite impossible to set
up new ones. Thus, from its
birth, the cotton industry was free
of the heavy yoke which
weighed on the older industries.
No regulations prescribed the
length, the breadth or the quality
of its materials, or imposed
or forbade the methods of manufacture.
There was no control save
that of individual interest and
of competition. Because of
this, machinery quickly came into
general use, bold ventures
were made and many kinds of goods
were manufactured. There was

17
 the same freedom with regard to labor. Neither the trade guild.

with its time-honored traditions, nor the system of

apprenticeship with its strict rules, ever existed in the cotton

industry.[26)

As the scope of the new industries expanded, the share of the

economy which was free of restriction expanded as well. And under

pressure from the advocates of laissez-faire, many old restrictions

were abolished as well. As a result, T.S. Ashton writes, "The State

came to play a less active, the individual and the voluntary

association a more active, part in affairs. Ideas of innovation and

progress undermined traditional sanctions: men began to look forward,

rather than backward, and their thoughts as to the nature and purpose

of social life were transformed."[273 Thus the concept of freedom

went beyond simple freedom from state coercion to freedom from

outmoded thinking and cultural restr~i't as well. And this too

helped contribute to the atmosphere of innovation and invention which

characterizes the Irdustrial Revolution.

Hence, there can be little question that economic freedom was a

major factor setting the Industrial Revolution in England into

motion. This concept carried over into the area of tax policy as

well. As David Ricardo wrote, "There are no taxes which have not a

tendency to lessen the power to accumulate."[28] Thus the

government's policy should be to keep the burden of taxation as
low
as possible. "It should be the policy of governments," Ricardo said,

"never to lay such taxes as will inevitably fall on capital; since by

so doing, they impair the funds for the maintenance of labor, and

thereby diminish the future production of the country."[29]

 Adam Smith put his views on taxation
into four famnus maxims:
1. "The subjects of every state ought to contribute towards te
support of the government, as nearly as possible, in proportion t',
their respective abilities;
that is in proportion to the revenue
which they respectively enjoy under
the protection of the state."
2. "The tax which each individual is bound to pay ought to be
certain, and not arbitrary."

"Every tax ought to be levied at the time,

or in the manner,
in which it is most likely to be convenient for
the contributor to
pay it."

4. "Every tax ought to be so contrived as

both to take out and
to keep out of the pockets of the people
as little as possible, over
and above what it brings into the public treasury of
the state."
Smith explained his last maxim
as meaning that the actual
cost
of tax collection, such as the hiring of revenue agents, should be as
low as possible; that penalties fur tax evasion should not be
excessive; that the burden of record keeping and documentation
be
kept as low as possible; and that taxes should be so structured as to
discourage as little industry and production
as possible.[ 30]
These principles were widely
adhered to throughout the
19th
century in Britain and carried over considerably
to Britain's
colonies.[ l] These principles applied in
the United States as well,
where state intervention in the economy was largely
limited to
protecting property rights,
national defense, and some public workt:.
In fact, there was no income tax until iQ13, except for two brief
periods during and after the Civil War. And large-scale taxation and
government intervention in the economy did not really begin until the

19
onset of World War II. Thus one migriL say that for the first 150

years of America's history as an independent nation, government

adhered to a limited role in the economy.[32]

Nor is there evidence that government played much of a role in

the rejuvenation of the economies of Germany or Japan following World

War II. In Germany, for example, economic recovery did not begin

until the economics minister, Ludwig Erhard, abolished the system of

economic controls imposed by the Nazis and continued by the Allies,

which permitted the nation to profit from its latent reservoir of

human capital.[33] Erhard also instituted a currency reform which

stopped inflation and began a series of tax reforms which sharply

reduced tax rates.

Until the Erhard reforms in 1948 the 50 percent marginal tax

rate began at 2,400 Reichsmarks (about $600) and the 95 percent

bracket started at an income of only 60,000 Reichsmarks (about

4:15,000). Indeed without a thriving black market outside the reach

of tax authorities, combined taxes on income and property might equal

or even exceed total income. As a result, almost half of all taxes

went unpaid. J34]

Beginning in 1948, however, tax rates were sharply cut. As

Table i indicates, the personal exemption was increased and the tax

brackets stretched-out, so that high rates affected fewer and fewer

people. Eventually, the rates themselves were cut, with the top rate

falling to 53 percent by 1958, which is close to the current top

marginal tax rate.[35]

 Table 1
Individual Income Tax Rates in West Germany (in Reichsmarks or

DeUtchmarks)

---------------------------------------------------------------------
Personal Income at which Income Where
Feriod Exemption 50% Rate Begins Top Rati Top Rate Begins

---------------------------------------------------------------------
1946-1948 600 2,401 95% 60,000
1948-1949 750 9,001 95 250,000
1950-1952 750 20,001 95 250,000
1953 750 36,001 82.25 220,000
1954 600 45,001 60 220,000
1955-1957 900 125,001 63.45 605,001
1958-1966 1,710 78,420 53 110,040

---------------------------------------------------------------------
Source: larl
Hauser, "West Germany," in Foreign Tax Folicies
and
Economic Growth (New York: Columbia
University Press, 1966), p. 147.

A similar experience occurred in postwar

Japan. During the
initial period of American occupation, the
principal problem was
spiraling inflation. Unfortunately, the tax policies of the American

authorities initially made things worse.

These included (1) higher
and more steeply graduated individual income
tax rates and lower
personal exemptions, (2) higher corporate and excess profits taxes

with no inflation adjustment for depreciation

allowances, (3) a heavy
capital levy on wealth, and (4) an increase in the number of sales

and excise taxes, including a VAT. t36]

Th.;se disastrous tax changes soon led to a breakdown of the

21
tax-payment system. Tax evasion was widespread, tax collectors

became as hated as the prewar secret police, businesses were falling

apart because they could no" replace capital, and revenues seriously

lagged. At this point, General Douglas MacArthur, head of the

American occupation forces, invited Professor Carl Shoup of Columbia

University and a group of other American tax experts to visit Japan

and make recommendations for the reform of the Japanese tax system.

Their first recommendation was a sharp reduction in tax rates and an

increase in personal exemptions. The top tax rate was reduced from

85 to 55 percent, the personal exemption was raised from 15,000 to

24,000 Yen, and a tax credit of 12,000 Yen per dependent was

instituted. With regard to business, the Shoup Mission recommended

adjustment of depreciation allowances for inflation, abolition of the

*xcess profits tax, and reduction of the corporate tax rate to 35

percent. In addition, numerous technical reforms were recommended

and instituted. After its recommendations had been implemented, the

Shoup Mission declared that Japan now had one of the best tax systems

in the world. J37)

Since then, the Japanese have continued to reduce tax rates and

expand incentives for saving and investment.[38] This has helped

give Japan one of the highest rates of economic growth in the postwar

era and made Japan the third greatest economic power in the world.

The development of industrialization in each case took place in

an environment of economic freedom and low taxes. But is this

experience really transferable to the present day Third World?

 Taxdtlon and Development in the Third
World

The best example is Hong Kong (see Chapter IV), where there is
essentially a 17 percent flat-rate tax
system for all citizens. It
dlso has very few government regulations
or any other interferences
with the free market. Indeed, Hong Kong has the freest economy
in
the world and one of the nest vigorous, especially considering
its
acute population density and almost
total lack of natural resources.

Thus Rabushka says:

Free trade, free markets, low taxes,

nonintervention, a-:d
personal liberty combine to demonstrate that the
free-market
model of economic organization can be
a living reality and not
Jutst a textbook convention. Hong Long can Ferve as a model for
other developing countries that have
thus far relied on a
state-directed path of economic development
but have failed to
complete the transition to a more prosperous
modern economy.[39)
Recent evidence suggests -- contrary
to conventional wisdom --
that Hong Long's spectacular postwar
growth rate led to a mcre even
distribution of income, despite the
lack of redistributionist tax
policies.[40) This is important because one frequently
cited
justification for high tax rates
is a fear that lower rates would

bring a more uneven income distribution.

E41]
Indeed, rapid growth based on free markets
and low taxes has
narrowed the distribution of income
between the highest and lowest
income classes in such countries as
Singapore, Taiwan and South
Korea.[42] In Taiwan, for example, Theodore Schultz
notes there is
"fairly firm evidence that the extraordinary
growth in per capita

23
inc.,me has appreciably reduced the inequality, lar-gely from rapid

investment in schooling, (that) has made people more available to the

jobs out of agriculture into many kinds of industries and willing to

migrate."E43J Gary Fields has shown that Brazil is another case

where rapid growth based largely on economic freedom led to an

evening of the income distribution.[44]

A recent World Bank study by Keith Marsden, who studied a number

of high-tax and low-tax LDCs, reported that higher rates of economic

growth allowed a substantial rise in real living standards in tne

low-tax countries, shown by their higher levels of private

consumption. At the same time, growth expanded the tax base and

generated increased revenues, which financed more rapid expansion of

expenditure on government services such as defense, health, arid

education. As a result, the share o.F income of the poorest

households remained relatively high. Therefore, he says, "available

data on income distribution seem to refute the argument that

countries with high taxes are more equitable than those with low

ones."[45]

Recent evidence suggests that the success of the East Asian

countries in obtaining high rates of growth through a low tax policy

and the wide publicity given to tax-cutting efforts in the U.S. is

causing "supply-side" -- pro-growth -- thinking to penetrate the

Third World.[46] India, for example, has sharply cut tax rates in

recent years. The top rate, which went as high as 97.75 percent was

cut in 1975 to 77 percent, leading to a surge of growth. A year

later the top rate was cut to 66 percent, stimulating further

growth. Most recently, Prime Minister Rajiv Ghandi instituted a new

- 9'
round of tax cuts and deregulation
measures, dropping the top rate
to
just 50 percent. Again, the impact has been quite
positive, with the
Indian stock market surging to new
records almost immediately.[47)

Other developing countries where

tax cuts and free market
strategies appear to have had significant
positive effects include
Sri Lanka[48], Chile[49], the Ivory Coast[50], Indonesia[51],
and
Botswana[52]. Conversely, tax increases and government
intervention
have adversely affected the performance
of many developing economies.

25
 Notes to Chanter II
1. See Alan A. Tait et. al., "International Comparisons of Taxation
for Selected Developing Countries," International Monetary Fund
Stdaf Fagcs 26(March 1979), pp. 123-56; Raja a. Chelliah et.
al., "Tax Ratios and Tax Effort in Developing Countries,

1969-71," International Monetary Fund Staff Fapers 22(March

1975), pp. 187-205; Raja J. Chelliah, "Trends in Taxation in

Developing Countries," International Monetary Fund Staff Fapers

1B(July 1971), pp. 254-331; Kilman Shin, "International

Differences in Tax Ratio," Review of Economics
and Statistics
51(May J969), pp. 21'-20; Jorgen R. Lotz and Elliott R. Morss,
"Measuring 'Tax Effort' in Developing Countries,"
International
Monetary Fund Staff Papgrs 14(Ncvember 1967), pp. 478-99; U Tun
Wai, "Taxation Problems and Policies of Underdeveloped

Countries," International Monetary Fund Staff Papers 9(November

1962), pp. 428-48; Roy Bahl, "A Regression Approach to Tax

Effort and Tax Ratio Analysis," International Monetary Fund
Staff EApg:2 18(Novembar 1971), pp. 570-612; Harley Hinrichs,
"Determinants of Government Revenue Shares
Among Less-Developed
Countries," Economic Journal 75
(September 1965), pp. 546-56;
Richard Thorn "The Evolution of Public Finances
During Economic
Development," Manchester School of Economic
and Social Studies
35
(January 1967), pp. 19-53; and Vito Tanzi, "Comparing
International Tax 'Burdens': A Suggested Method," Journal of
Folitical Economy 76(Sept.-Oct. 1968), pp. 1078-84; Robert
Summers, Irving Kravis, and Alan Heston, "International
Comparisons of Real Product and Its Composition: 1950-77,"
 Review of Income and WealTh 26(March 1980), pp. 19-66; Alison

Martin and W. Arthur Lewis, "Patterns of Public Revenue and

Expenditure," Manchester School of Economic and Social Studies

24(September 1956), pp. 203-44; Harry T. Oshima, "Share of

Government in Gross Natioial ProduLt for Various Countries,"

American Economic Review 47(June 1957), pp. 381-90; and Vito

Tanzi, "Quantitative Characteristics of the Tax Systems of

Developing Countries," in D. Newbery and N. Stern, eds., Modern

Tax Theory for DeveLQing Countries (Washington: World Bank,

forthcoming). For criticism of this analytical method, see

Richard M. Bird, "Assessing Tax Performance in Developing

Countries: A Critical Review of the Literature," Finanzarchiv

24(1976), pp. 244-65; and M.M. Ansari, "Tax Ratio and Tax Effort

Analysis: A Critical Evaluation," Bulletin for International

Fiscal Documentation 37(August 1983), pp. 345-53.

2. The term was coined by Professor Herbert Stein of the University

of Virginia; see Herbert Stein, Presidential Economics (New

York: Simon and Schuster, 1984), p. 241. For general

discussions of supply-side economics, see Victor A. Canto,

Douglas H. Joines, and Arthur B. Laffer, Foundations of

S221x-Side Economics (New York: Academic Press, 1983); Federal

Reserve Bank of Atlanta and Emory University Law and Economics

Center, Supglj-Side Economics in the 1980s (Westport, CT: Quorum

Books, 1982); George Gilder, Wealth and Poverty (New York: Basic

Books, 1981); Jude Wanniski, The Way the World Works (New York:

Basic Books, 1978); Paul Craig Roberts, The Su2pL-Side

Revolution (Cambridge, MA: Harvard University Press, 1984);

27
 Michael K. Evans, The Truth About Suply-Side Economics
(New
York: Basic Books, 198'3); Bruce Bartlett and Timothy Roth, eds.,

Ihe QSUaQy-Side Solution (London: Macmillan, 1983); Richard H.

Fink, ed., SUcDly-Side Economics: A Critical Appraisal
(Frederick, MD: University Publications of America, 1982);

Thomas J. Hailstones, ed., ViewgQints on SuQpLy-Side Economics

(Richmond, VA: Robert F. Dame, 1982); and Laurence H. Meyer,

ed., The Sunply-Side Effects of Economic Policy (St. Louis, MO:
Federal Reserve Bank of St. Louis and Center for the Study
of
American Business, Washington University, 1981).

3. See, for example, Edward F. Denison, "A Note on Private

Saving,"
Review of Economics and Statistics 40(August 1958),
pp. 261-67;
Paul A. David and John L. Scadding, "Private Saving,

Ultrarationality, Aggregation, and 'Denison's Law,'" Journal of

Political Economy 82(March/April 1974), pt. 1, pp. 225-49.
4. Lawrence H. Summers, "The After-Tax Rate of Return
Affects
Private Savings," American Economic Review 74(May 1984), pp.

249-53.

5. See, for example, George F. Break, "Income Taxes,

Wage Rates,
and the Incentive to Supply Labor Services," National
Tax
Journal 6(December 1953), pp. 333-52.
6. Jerry A. Hausman, "Labor Supply," in Henry Aaron and Joseph A.
Pechman, eds., How Taxes Affect Economic Behavior (Washington:
The Brookings Institution, 1981), pp. 27-64; Harvey S. Rosen,
"What Is Labor Supply and Do Taxes Affect It?" American Economic

Review 70(May 1980), pp. 171-76.

7. See, for e:;ample, James Gwartney and James Long,
Income Tax
 Avoidance and an Emplrical Estimation of the Laffer Curve

(Washington: Department of the Treasury, Office of the Assistant

Secretary for Economic Policy, 1984); Charles Stuart, "Swedish

Tax Rates, Labor Supply, and Tax Revenues," Journal of Political

Economy 69(October 1981), pp. 1020-38; Alan Peacock, "The

Disaffection of the Taxpayer," Atlantic Eco.nomic Journal

11(March 1983), pp. 7-15; Carl Shoup, "Economic Limits to

Taxation," Atlantic Economic Journal 9(March 1981), pp. 9-23;

Vito Tanzi, ed., The Underground Economy in the United States

and Abroad (Lexington, MA: Lexington Books, 1982).

6. Nicholas (Lord) Kaldor, "Will Underdeveloped Countries Learn to

Tax?" Foreign Affairs (January 1963), reprinted in Richard M.

Bird and Oliver Oldman, eds., Readings on Taxation in Develogi ng

Countries, 3rd ed. (Baltimore, MD: The Johns Hopkins Press,

1975), p. 31.

9. Quoted in Stanley Please, "Saving Through Taxation--Reality or

Mirage?" Finance and Develomnent 4(March 1967), reprinted in

Bird and Oldman, Readings, p. 40. It should be noted that Goode

is not unaware of the limits to taxation; see Richard Goode,

"Limits to Taxation," in Karl W. Roskamp and Francesco Forte,

eds., Reforms of Tax Systems (Detroit, MI: Wayne State

University Press, 1981), pp. 41-54; idem, Governmental Finance

in Developing Countries (Washington: The Brookings Institution,

1984), pp. 95-98.

10. Walter Heller, "Fiscal Policies for Underdeveloped Countries,"

in Bird and Oldman, Readings, p. 27.

11. Barbara Ward, "Taxing the Rich Countries to Aid the Poor,"

29
 Washington Post (December 18, 1977).
12. W. Arthur Lewis, the Theory of Economic Growth (Homewood, IL:

Richard D. Irwin, 1955), p. 231.

13. P.T. Bauer and B.S. Yamey, Ihe Economics of Under-Developed

Countries (Chicago: University of Chicago Press, 1957), pp.

196-7.

14. Ibid., p. 199.

15. Ibid., pp. 199-200.

16. Ibid., pp. 201-3.

17. See, for example, Israel M. Kirzner, "Entrepreneurship
and the
Market Approach to Development," in Perception, Oppgrtunity, ad

Profit: Studies in the Theorv of Entregreneurshi (Chicago:

E

University of Chicago Press, 1979), pp. 107-19; Harvey

Leibenstein, "Entrepreneurship and Development," American

Economic Review 58(May 1968), pp. 72-83. For a classic

statement, see Joseph Schumpeter, The Theory of Economic

Develgoment [19343 (New York: Oxford University Press, 1980).

16. John Maynard Keynes, Essays in Persuasion [19313 (New York:

Norton, 1%63), pp. 272-3.

19. J.R. Hicks, Value and Capital, 2nd ed. (New York: Oxford
University Press, 1946), p. 64. According to Friedman, Alfred

Marshall made much the same point; see Milton Friedman, "The

Marshallian Demand Curve," Journal of Political Economy

57(December 1949), reprinted in Essays in Positive Economics

(Chicago: University of Chicago Press, 1953), pp. 47-99.

20. Ludwig von Mises, Human Action (New Haven, CT: Yale University

Press, 1949), p. 616.

 21. Thomas Sowell, Classical Economics Reconsidered (Princeton, NJ:

Princeton University Press, 1974), pp. 20-4.

22. These were numerous; for details, see Alvin Rabushka, From Adam

Smith to the Wealth of America (New Brunswick, NJ: Transaction

Books, 1965), pp. 5-15. See also Joseph J. Spengler, "Adam

Smith's Theory of Economic Growth--Part I," Southern Economic

Journal 25(April 1959), pp. 397-415; idem, "Adam Smith's Theory

of Economic Growth--F'art II," Southern Economic Journal 26(July

1959), pp. 1-12.

23. Adam Smith, The Wealth of Nations [1776] (New York: Random

House, Modern Library, 1937), p. 329.

24. Ibid., p. 508.

5 Faul Mantoux, The Industrial Revolution in the Eighteenth

Century [1928) (Chicago: University of Chicago Pres;s, 1963), p.

260.

26. Ibid., pp. 260-1.

27. T.S. Ashton, The Industrial Revolution, 1760-1830 [1947) (New

York: Oxford University Press, 1972), p. 4.

28. David Ricardo, The Principles of Political Economy and Taxation

[1817) (New York: E.P. Dutton, 1911), p. 95.

29. Ibid., p. 96.

30. Smith, Wealth of Nations, pp. 777-6.

31. Rabushka, From Adam Smith, pp. 38-71. See also Ronald Max

Hartwell, "Taxation in England During the Industrial

Revolution," Cato Journal 1(Spring 1981), pp. 129-53.

32 In general, see Bernard H. Siegan, Economic Liberties and the

Constitution (Chicago: University of Chicago Press, 1980);

31
 Jonathan R.T. Hughes, The Governmental Habit (New York: Basic

Books, 1977); Douglass C. North, The Economic Growth of the

United States, 1790-1860 (New York: W.W. Norton, 1966); and

Sidney Ratner, James H. Soltow, and Richard Sylla, The Evolution

of the American Economy (New York: Basic Books, 1979).

33. On the continuation of economic controls, see Henry Hazlitt,

"The German Paralysis," Newsweek (April 21, 1947), p. 82; and

John Davenport, "New Chance in Germany," Fortune (October 1949),

pp. 72-76. On the Erhard reforms, see Ludwig Erhard, ProsppEity

Throghg Cope tition (New York: Fraeger, 1958), p. 10-20; F.A.

Lutz, "The German Currency Reform and the Revival of the German

Economy," Economica 16(May L949), pp. 122-42; Walter Heller,

"Tax and Monetary Reform in Occupied Germany," National Tax

Journal 2(September 1949), pp. 215-31; idem, "The Role of

Fiscal-Monetary Policy in German Economic Recovery," American

Economic Review: apers and Proceedings 40(May 1950), pp.

531-47; and Egon Sohmen, "Competition and Growth: The Lesson of

West Germany," American Economic Review 49(December 1959), pp.

986-1003.

34. See Karl Hauser, "West Germany," in Foreign Tax Policies and

Economic Growth (New York: Columbia University Press, 1966), pp.

113-117.

35. Individual Taxes: ) Worldwide Summary (New York: Price

Waterhouse, 1985), pp. 83-85.

36. Martin Bronfenbrenner and Kiichiro Koqiku, "The Aftermath of the

Shoup Tax Reforms, Part I," National Tax Journal 10(September

1957), pp. 236-54.

 37. Ibid.
.8. See Joseph A. Pechman and Keimei
Kaizuku, "Taxation," in Hugh
Patrick and Henry Rosovsky, eds.,
Asia's New Giant: How the
Ja2anese Econgmy Works (Washington: The Brookings Institution,

1976), pp. :17-82.

See also U.S. Congress, Joint Economic
Committee, Japanese Tax Policy, 98th Congress,
2d session

(Washington: U.S. Government Printing

Office, 1965).
39. Rabushka, From Adam Smith, p. 147. See also Alvin Rabushka,

Hong KLong: A Study in Economic Freedom (Chicago:

University of
Chicago Press, 1979); idem, The Changing Eac
of Hong L ng
(Washington: American Enterprise
Institute, 1973); idem, Free
Markets and Economic Devel oment
in Postwar Develoging Cgntries

(Washington: Agency for International

Development, 1983), pp.
14-25; P.T. Bauer, EggaIity, the Tird World, and Economic
Delusion (Cambridge, MA: Harvard University
Press, 1981), pp.
165-90; Mary Lai, "15 Percent Tax -- And Still Taxpayers
Grumble," Bulletin for International
Fiscal Documentation 36(May
1962), pp. 197-99; and Doing Business in Hong K~qg
(New York:
F'rice Waterhouse, 1983).
40. Steven C. Chow and Gustav F. Fapanek,
"Laissez-Faire, Growth and
Equity -- Hong Kong," Economic
Journal 91(June 1981), pp.

466-85.
41. See, for example, Jacques Lecaillon
et. al., Income Distribution
aq Economic Develogment (Geneva: Inter-national Labour Office,

1964).

42. Rabushka, From Adam Smith, pp.

149-77.
43. Quoted in "Frosperity, Society, and How
They Are Linked," New

33%
 York Times (May 6, 1984), p. E5. See also S.C. Tsiang,

"Taiwan's Economic Miracle: Lessons in Economic Development," in

Arnold Harberger, ed., World Economic Growth: Case Studies of

Develo2ed and Developing Natioans (San Francisco: Institute for

Contemporary Studies, 1984), pp. 322-3.

44. See Gary S. Fields, "Who Benefited from Economic Development? --

A Reexamination of Brazilian Growth in the 1960s," American

Economic Review 67(September 1977), pp. 570-82; M. Louise Fox,

"Income Distribution in Post-1964 Brazil," Journal of Economic

History 43(March 1983), pp. 261-71; and Guy Pfeffermann and

Richard Webb, "Poverty and Income Distribution in Brazil,"

Review o+ Income and Wealth 29(June 1983), pp. 101-24.

45. Keith Marsden, Links Between Taxes and Economic Growth: Some

Empirical Evidence (Washington: World Bank, Staff Working Paper

No. 605, 1963), pp. 4-5.

46. See, for example, Everett G. Martin, "Some Frustrated Third

World Nations Have Found Another Economic Guru," Wall Street

Journal (September 24, 1980), p. 34; Richard F. Janssen,

"Tomorrow the Third World? American Supply-Siders Looking At

Poor Nations," Wall Street Journal (M~irch 25, 1981), p. 32; Fred

Barnes, "Third World Counterrevolutionaries," The American

Spectator (November 1981), pp. 23-26.

47. See Wanniski, Way the World Works, pp. 249-50; Anil Kumar Jain

and Inu Jain, "A Brief Review ci+ the Indian Tax System,"
Bulletin for International Fiscal Documentation 37(May 190F),

pp. 215-21; Steven R. Weisman, "Tax-Cut Proposal in India Budget

Recalls Reagan Plan for Stimulus," New York Times (March 25,
 1985), pp. Al, D5; Je'trey B. Johnson, "New Measures In Indian
Fitid t Signal Ttzrn in Economic Policy," BsU!rIess America (April
15, 1985), pp. ,2-33;
Anoop Singh, "New Economic Policy
Initiatives in India Aim At Spurring Efficiency,
Productivity,"
IMF Survey (June 10, 1985), pp. 178-60; Paul Gigot, "Halfway
Across the Ganges," Wall Street JoEural (April 10, 1985), p. 28;
Catherine Gwin and Lawrence A. Veit, "The Indian Miracle,"
Foreign Policy (Spring 1965), pp. 79-98; Steven R. Weisman,
"India's "Teji" (Bull) Market," New York Times (August 14,

1965), pp. D1, D5.

48. Alvin Rabushka, Free Markets and
Economic Develoqment, pp.
97-106; idem, "Sri Lanka's Experiment in Economic
Liberalis,i,"
Wall Street Journal (May 18, 1981), p. 27; Devinda R.
Subasinghe, "Rest of Third World Can Profit From
Sri Lanka's
Example," Wall Street Journal (August 22, 1983), p. 15; Pranay
Gupte, "Third World Success Story," EEorbe (June 18, 1984), pp.
62-68; and Devinda R. Subasinghe, Now, A Ci Lankan Free Market
Economic Miracle (Washington: Heritage Foundation,
Asian Studies

Center Backrounder No. 27, 1985).

49. For positive comments on
the Chilean situati'1on, see Victor A.
Canto, Arthur B. Laffer, and Carol V. Lopilato, Chile: A
Classical Path to Pros e Ety (Los Angeles: A.B. Laffer Assoc.,
1981); Peter Dworkin, "Chile's Brave Nes World
of Reaganomics,"
Fortune (November 2, 1981), pp. 136-44; Claudia Rosett "Chile's
Economic Revolution," Reason (April 1982), pp. 32-39; Sebastian
Edwards, Economic Pol'icy
gad the ecgE o± Eggnomic Growth in
Chile in the 1970's and 1980's (Los Angeles: UCLA, Department of

35
 Economics Working Paper No. 283, 1983); Claudia Rosett, "An

Aborted Economic Test," New York Times (July 3, 1983); David

Gallagher, "Chile After the Fall: Free-Market Policy Gradually

Vindicated," Wall Street Journal (May 31, 1985), p. 23. For

criticism, see Vincent Parkin, "Economic Liberalism in Chile,

1973-82: A Model for Growth and Development or a Recipe for

Stagnation and Impoverishment?" Cambridgqe Journal of Economics

7(June 1983), pp. 101-24; Alvaro Garcia and John Wells, "Chile:

A Laboratory for Failed Experiments in Capitalist Political

Economy," Cambridge Journal of Economics 7(September-December

1983), pp. 287-304; and Ricardo Ffrench-Davis, "The Monetarist

Experiment in Chile: A Critical Survey," World Development

11(November 1983), pp. 905-26. See also Rabushka, Free Markets

and Economic Develogment, pp. 83-96; Alejandro Foxley, Latin

American Exgeriments in Neo-Conservative Economics (Berknly:

University of California Press, 1983); and Nicholas Ardito

Barletta, Mario I. Blej2!r, and Luis Landau, eds., Economic

Liberalization and Stabilization Policies in Argentina, Chile,

and Urugggy (Washington: World Bank, 1983).

50. Rabushka, Free Markets and Economic Devel ogment, pp. 70-82; and

Wanniski, !A the World Works, pp. 251-55.

51. Malcolm Gillis, "Episodes in Indonesian Economic Growth," in

Harberger, ed., World Economic Growth, pp. 263-4.

52. Alan Reynolds, ThR UrgeC y of International Tax Relief

(Morristown, NJ: Polyconomics, 1985), pp. 12-13; and Stephen R.

Lewis, Jr., "Democracy Enables Botswana to Cope With Drought,"

Wall Street Journal (August 28, 1985), p. 19.

36
 CHAPTER Ill

IMPLICIT TAXES

While explicit taxes are

important, implicit taxes
also have
significant -- perhaps more
significant -- effects on
the economies
of less developed countries.
These implicit taxes include
a whole
range of governmental regulations,
controls, subsidies, tariffs,
and
exchange rate policies, which
impact on incentives in much
the same
way that marginal tax rates
do. This chapter reviews some
of these
implicit taxes and their
effect on incentives.
The most important implicit taxes
in the developing world
consist of price controls,
especially in agriculture.
They exist for
many reasons, including misguided
efforts to control inflation
res-ultinq from incorrect
monetary and fiscal policies,
the desire by
politicians to curry favor
with urban voters by maintaining
artificially low food prices,
and because governments frequently
derive significant revenues
from reselling commodities
obtained at
below market prices at higher
prices on the international
market.
Whatever the motive, however,
the effects and pervasiveness
of
price controls have come
to be recognized as a significant
deterrent
to growth in the LDCs.[1]
This is because price controls
constitute
an implicit tax. If a farmer must sell his
produce to a state
procurement agency at a price
which is 25 or 50 percent
below the
world market price, it is
the same as if he had paid
a 25 or 50
percent tax on his production
at the free-market price.
As a recent World Bank study
notes, "when governments intervene
in the pricing mechanism
it usually is not a marginal
intervention

37
but a very large one that has serious efficiency implications."[2]
A
typical example is Jamaica, as the following table demonstrates:

Table 1

Border Price and Domestic Price for Major Commodities in Jamaica,

1979 ($J/ton)

- ----------------------------------------- ---------------------------
Product Farmgate Price Export Price Implicit Tax Rate

---------------------------------------------------------------------
Sugar 190 396 527
Bananas 145 763 81%
Cocoa 2,404 5,226 54%
Coffee 812 1,249 35%

---------------------------------------------------------------------
Source: Malcolm D. Bale, Ag[icultural Trade and Food Policy: The
E ierience of Five Developing Countries (Washington: World Bank,
Staff Working Paper No. 724, 1985), p. 18.

In other cases, domestic prices are subsidized in order to

reduce imports of substitutes. In this case, the implicit tax on

domestic producers is simply replaced by an implicit tax on

importers. An example of this is Columbia, as in Table 2.

I/
 Table 2

Border Price and Domestic Price for Major

Commodities in Columbia,

1979 (pesos/t00 kg)

---------------------------------------------------------------------
Product Market Price Border Price Implicit Tax
--- ----------------------------------------------------------------
Wheat 1,978 1,036 48%
Corn 2,015 1,126 44%
Sorghum 1,728 823 52%
Soybeans 3,280 1,773 46%

--- ----------------------------------------------------------------
Source: Bale, Agricultural Trade, p. 18

Efforts have been made to measure the

efficiency loss from
agricultural price distortions. While methodologies vary, virtually
all research estimates the losses to be
significant, amounting to
hundreds of millions of dollars and several
percentage points of GNP
in some cases.[3] One study estimated that elimination of

below-market pricing policies could increase

agricultural output as
much as 60 percent and increase national
income growth more than 3

percent per year.[4]

Such etimates are often disputed for

the same reason that the
supply response to tax cuts has often
been disputed in the U.S. It
is often claimed that the "income effect"
will outweigh the
"substitution effect," thereby causing output to fall, rather than
rise, in response to higher prices.

The rationale claims that, first, the subsistence

sector is risk.

39
averse and values leisure and other activities highly.

Second, it assumes that farmers in developing countries

have income targets. Thus if the producer price is increased, the

production of a smaller amount of the commodity will provide the

necessary income; i.e., a backward-sloping supply curve for labor.

This hypothesis has been thoroughly examined by Marian Bond

of the IMF. She found that "for both individual crops and aggregate

production, supply responses are positive." The existence of a

backward-sloping supply curve for labor "is not supported by the

evidence."[5] In short, residents of LDCs react to prices and

incentives the same way those in the industrialized countries do. As

a recent World Bank study put it:

The greater the importance in farm output of the products

for which official prices are set artificiilly low, the

greater the tendency for farmers to return to subsistence

farming, to smuggle crops to neighboring countries where

controls are less rigorous or where prices are higher,

arid/or to leave the land for the city in the pursuit of

relatively higher income. The result is a decline in

aggregate production. J6]

Moreover, the production loss in the long-run is greater

than in the short-run, because the loss of income to farmers reduces

their ability to save and invest in agriculture. It also reduces

their credit-worthiness, making it difficult to obtain inputs and

equipment which would increase their yield. As investment in

agriculture declines, so will output.[7]

,­
 Implicit Taxes on Labor

Interference with the price system in developing countries

is not limited to the agricultural sector. Many LDCs employ minimum

wage laws and other policies which artificially raise the
price of
labor.[8] This, too, is an implicit tax. If an employer must pay 50
percent more for labor than the free-market would command,
this is
equivalent to a 50 percent payroll tax. The result is that less
employment is created.[9] A recent World Bank study suggests that

such labor market distortions may reduce economic growth

in the LDCs
by as much as 10 percent.[10] The estimates are summarized in Table

Table Z

Distortions in Labor Costs and Growth Performance (percent)

--------------------------------------------------------------------

Distortions

High Medium Low

--- ----------------------------------------------------------------
GDP Growth Rate 4.5 4.7 5.9
Domestic Savings Ratio 12.5 17.5 20.4
Return on Investment 20.2 21.3 26.5
Growth Rate of Industry 4.3 6.1, 7.3
Growth Rate of Agriculture 2.7 2.5 3.4
Growth Rate of Exports -0.3 2.7 6.5

--- ----------------------------------------------------------------
Source: Ramgopal Agarwala, Price Distortions and Growth in
Develoging
Countries (Washington: World Bank, Staff Working Paper No.
575,
1983), p. 27.

41
Implicit Taxes on Trade

Foreign exchange and investment policies constitute further

areas of price distortion and implicit taxation in most LDCs.

Exchange controls are common in LDCs.[11] The goal is usually to

maintain overvaluation, which subsidizes imports and penalizes

exports. As Ronald McKinnon puts it: "Since exporters sell in

foreign markets at this less than favorable 'real' exchange rate,

they are caught in a profit squeeze, which reduces traditional

exports and blocks new export development -- particularly of

manufacturers."[12]

Exchange controls are frequently combined with restrictions on

foreign direct investment. As a result, LDCs have relied heavily on

bank loans in recent years to finance domestic investment. This

proved to be a tragic mistake. Unlike direct investments, which only

repatriate earnings if there is a profit, bank loans come with

i'-front fees and semi-annual interest payments (in hard currency)

v.-hich m:;.!t be made regardless of whether the investment yields a

profit. Moreover, since such interest payments generally float at

the U.S. prime rate, any increase in U.S. interest rates increases

Third World debt payments.

The problem is complicated not merely by the unprofitability of

many of the investments made by Third World countries, which often

take the form of government enterprises or parastatals, but the fact

that even profitable investments are required to yield foreign

exchange. Thus any investment in a non-export industry or one which

increases imports is necessarily bad, even if it yields large profits

42
 or other benefits.

Of course, the number of government-directed LDC investments

which yield any benefits whatsoever is exceedingly small.

As a
recent World Bank report notes, such investments invariably
become
politicized, there are seldom any skilled managers available
to run
such enterprises, and the availability of government
subsidies, trade
protection, and grants of monopoly status not only eliminate
any
incentive to be efficient but also eliminate much of
the critical
market information generated by the price system. Thus the World
Bank has strongly urged developing nations to move away
from
intervention and allow market forces to operate more
freely.[13]

As long as bank loans were easily available there was

little
incentive for Third World countries to heed such advice.
The
improvement in investment opportunities in the U.S. and the Third

World debt crisis, resulting from high real interest rates and the

rising dollar, however, led to a very sharp cutback in

foreign loans
by U.S. banks. In 1982 U.S. banks's claims on foreigners increased

by over $111 billion. By 1984 this fell to $8.5 billion. Bank loans
to Mexico, for example, which were over :-7 billion in
1982, became a
net flow of $200 million from Mexico to the U.S. in
1984.[14]

Implicit Taxes on Capital

It is widely believed that LDCs can do little to raise

capital
on their own through saving, since many of them are so
poverty­
striken that they cannot feed themselves. In fact, many LDCs have

substantial amounts of capital. The problem is that their own

43
citizens invest abroad, rather than at home. As a result, capital

flight is a major problem, with capital outflows exceeding inflows in

some countries. (See Table 4.)

Table 4

Capital Flight and Gross Capital Inflows in Selected Countries,

1979-62 (billions of dollars)

-----------------------------------------------------------------------

Country Capital Flight Gross Capital Inflows

-----------------------------------------------------------------------

Venezuela 22.0 16.1

Argentina 19.2 29.5

Mexico 26.5 55.4

Uruguay 0.6 2.2

Portugal 1.8 8.6

Brazil 3.5 43.9

Turkey 0.4 7.9

Korea 0.9 18.7

-----------------------------------------------------------------------

Source: World DeveloQment Report 198), p- 64.

The World Bank blames capital fight primarily on overvalued

exchanges rates, which make foreign assets seem cheap and also incite

fears of devaluation; high and variable rates of inflation, which

create uncertainty and reduce real interest rates; repressive

financial policies, which maintain real interest rates at low or

negative levels; and high levels of domestic protection, which make

foreign debt harder to service.[15] Moreover, the assets acquired

44
 abroad do not play the same constructive role
played by the foreign
investment of the industrialized nations.
Whereas the repatriated
earnings of U.S. assets abroad, for example,
play a significant role
in reducing the current account
deficit, assets invested abroad by
LDC residents are unlikely
to be repatriated.
Therefore, these
4oreign assets are unlikely
to produce either tax
revenue or foreign
exchange with which
to strengthen the domestic
economy. However,
this stock of capital
could return to the
developing countries
if
they provided a secure
environment and an adequate
after-tax rate of
return. Sound policies can convert
capital outflow into
capital
inflow.

Much the same can be

said for foreign capital as well, which is
discouraged by many
of the same policies which
encourage capital
flight. In addition, however, most LDCs impose
special burdens on
foreign direct investment.
Such policies flow from
the colonial
experience and a desire
to remain free of foreign domination.
As a
recent World Bank report r.otes,
"Attitudes in developing
countries
toward private foreign
investment have...ranged
from catitious to

prohibitive."[16)

A recent International Monetary Fund study outlined a variety of

restrictions on foreign investment in LDCs.[17] These include
Politically sensitive
industries, such as public utilities,
broadcasting, publishing,
banking and petroleum. Some reserve to
locals those industries
with relatively sinple
technical and
financial requirements, such as wholesale and retail trade.
The permitted degree of foreign ownership
of all enterprises is
limited in many countries
and the takeover of existing local firms is

45
prohibited except in special circumstances. A number of countries

(including India, Mexico, the Philippines and Yugoslavia) generally

require that foreign investors hold only a minority equity position

in local enterprises. In some cases, foreign companies are required

to gradually relinquish ownership and control to local residents over

a specified period (Venezuela, Columbia, Ecuador, Peru, and Bolivia).

Remittances of interest and dividends on direct investment, as

well as fees for technology transfers, are subject to restriction in

various developing countries. Some (such as Greece) limit

remittances to a certain percentage of invested capital, while others

make overseas dividend transfers subject to additional taxation or

limit them to a proportion of the firm's foreign exchange earnings.

The I1F notes that such restrictions often backfire because they

ar',courage disguised remittances through artificial transfer prices

which may deny the host country its share of profits ur tax receipts,

such as having a foreign subsidiary sell products to the home office

at artificially low prices, thereby capturing the profit where it is

not subject to restriction. Moreover, dividend remittances are

sometimes subject to greater restrictions than interest payments on

lx.ns. This may encourage an excessive debt/equity leverage in an

affiliate's capital structure.

A growing number of countries impose specific performance

obligations on foreign-owned firms, most frequently in the form of

requirements for either a minimum level of exports or a given share

of domestic content in total output (such as in the auto industry in

most Latin American countries). Access to local capital markets is

restricted in many developing countries (including Argentina, Kenya,

 Nigeria, Peru, the Philippines
and Turkey). Many developing
countries have also imposed restrictions
that hinder foreign
portfolio investment. These include outright prohibition,
restrictions on the types of shares
in whIch foreign investment is
allowed, limits on capital repatriation,
lengthy minimum investment
periods, and above-average taxes
on dividends and capital gains.

Sorte developing countries are

slowly moving toward
liberalization of restrictions
on foreign investment.E1B Egypt,
Jamaica, the Philippines, and Turkey,
fo- example, have shifted from
detailed control of direct investment
to much more flexible
arrangements, while more gradual
policy changes have taken place
in
Korea, Mexico, Morocco, and Pakistan.
However, they are paying a
heavy price for past actions because
multinational companies are
reluctant to risk their capital
locally. They fear that current
policy changes may be only temporary
or cosmetic. Moreover, the very
lack of capital which has contributed
to slow growth in many
developing countries discourages
new foreign capital investments,

thus further retarding growth.E19]

Rising protectionism in the industrialized

nations is another
factor. As the IMF notes, although the
average level of tariffs in
the OECD countries has fallen to
just 5 percent on imports of
manufactured products, tariffs
remain much higher on precisely
those
products most significant to developing
countries. Tariffs average
119 percent on clothing, 13.5 percent
on footwear, and 12.5 percent on
textile fabrics. Moreover, although most industrialized
nations give
special preferencc= to ievelLiping
countries, such preferences are
often limited in important ways,
so that only half of eligible

47
imports received preferential treatment in 1980.[20]

Protection against developing nations' import! by industrialized

countries discourages investment in LDCs, since those sectors where

they have demonstrated a comparative advantage are exactly those

where protection is the greatest. Thus the greatest pressure for

increased protectionism in the U.S. comes i.. the footwear and textile

industries where developing nations excel. Obviously, therefore,

enactment of protectionist legislation against such imports will

reduce the opportunities for profitable investment in the LDCs.

Tariffs

Tariffs are another tax. When imposed by industrialized nations

on the products of LDCs, they are especially cruel. Developing

countries are also guilty of imposingj high tariffs on imports from

other developing countries. Unfortunately, given the difficulty of

raising adequate revenues through direct taxation in most LDCs, due

to administrative problems, they are often forced to rely excessively

on tariffs and export taxes for revenue-raising. Export taxes have

economic effects similar to tariffs.[21]

This is tragic because much recent research indicates that

exports are a powerful engine of development, as in the case of South

Korea.[e22 Bela Belassa, for example, has estimated that between

1966 and 1973 Chile, Mexico and India, which all had inward-lookinq

policies, would have had per capita incomes between 17 and 22 percent

higher had they achieved higher export growth.[23] Other research

has also confirmed the positive impact of outward-oriented policies

 on growth and adjustment to external shocks.[24]

Inflation

No discussion of barriers to investment and implicit taxes would

be complete without reference to the pervasive problem of inflation.

Inflation has two important tax-effects. First, it acts as a tax on

cash balances and financial assets. As Bela Be1 assa notes:

High and unstable -- and hence unanticipated -- rates of

inflation discourage the holding of financial assets unless

these assets are fully indexed, which is not the case in any

developing country. In particular, the lack of indexing of

demand deposits in the face of inflation represents a tax on

non-interest-bearing money holdings. This implicit tax, as well

ac: uncertainties pertaining to the real rate of interest on

financial assets, encourages people to substitute real assets

for financial assets.[25]

This situation is aggravated by the tendency in most LDCs io

hold nominal interest rates down administratively, creating low and

even negative real irterest rates. This produces lower rates of

saving and investment and, hence, economic growth. Negative real

interest rates also have a destabilizing effect throughout the

economy. Excessive demand for credit puts pressure on central banks

to increase the money supply and this feeds inflation.[26)

Inflation's second major tax effect is in its interaction with

the tax system itself. Inflation pushes people into higher tax

brackets in graduated rate systems, and erodes the value of

49
exemptions and credits, thereby raising the real burden of taxation.

It also forces taxes to be paid on illusory capital gains, reduces

the value of capital consumption allowances based on historical cost,

and reduces the return on saving, when the interest earned merely

reflects an inflation premium. While many of these problems can be

relieved with indexing, few countries fully index for inflation,

index in a timely manner, or have adequate indexes to entirely

prevent inflation from increasing the real tax burden.[27)

Inflation's causes are no different in the LDCs than in the

industrialized countries: sxcessive money creation. However, there

does appear to be a closer link between budget deficits and inflation

in LDCs than in the industrialized countries. This is because of the

wide existence of state industries, which almost invariably run

losses, requiring government subsidies. At least in Argentina, such

subsidies appear to have had a significant impact on money and credit

creation and, therefore, inflation.[28]

Statistical analysis indicates that inflation distortions

explain about 15 percent of the difference in growth rates between

countries, as Table 5 demonstrates.

4Q5bo
 Table 5
Inflation and Growth Performance in Selected
Developing Countries

(percent)

---------------------------------------------------------------------

Distortions

High Medium Low

-----------------------------------------------------------------
GDF Growth Rate
3.1 5.8 5.3
Domestic Savings Ratio 15.9 17.5 19.0
Return on Investmert 15.8 26.0 26.6
Growth Rate of Industry 3.6 7.1 7.4
Growth Rate of Agriculture
1.8 3.2 3.9
Growth Rate of Exports
2.1 3.5 5.2

---------------------------------------------------------------------
Source: Agarwala, Price Distortions, p. 33.

Utii last implicit tax which is mainly confined

to the developing
countries is a pervasive problem with corruption.
Bribes must
frequently be paid to obtain even the most
routine governmental and
nongovernmental services in many LDCs. Since, in many cases, such
corruption is, for all intents and purposes,
officially sanctioned as
a way of paying workers, bribery comes close
to constituting an

explicit tax.[29]

Summary

In conclusion, there are a whole range of

governmental actions

51
which can be categorized as implicit taxes, in that they
increase the
prices of goods, the cost of doing business, or lower the
rate of
return. While it is extremely difficult to calculate the precise

level of such "ta.<es," they impact on incentives in the same way that

explicit taxes do. Since such implicit may be of significantly more

importance than explicit taxes in determining a developing

country's
growth prospects, further research in this area should be
a high
priority, in order to quantify and catagurize such "taxes" and,

hopefully, lead to their reform.

 Notes to Cthd2tr
III
I. The World Bank made this point
a major theme of its 1983 report.
See World Development Egort
1983 (New York: Oxford University

Press, for the World Bank,

1983), pp. 57-63.
2. Malcolm D. Bale, 8gric-utural Trade and Food Folicy: The
Eeience of Five Devel oing
ContCies (Washington: World Bank,
Staff Working Paper No. 724,
1985), p. 17.

Many of these studies are summarized

in Ernst Lutz ano Pasquale
L. Scandizzo, "Price Distortions
in Developing Countries: A
Bias
Against Agriculture," EUC9oQan Review
of Agricultural Economics
7(No. 1, 1980), pp. 5-27. Recent estimates for several
countries
may be found in Bale, AgrLicultural
Trade, p. 20. See also
Malcolm D. Bale and Ernst Lutz, Price
Distortions in Agriculture
and Their Effects: An International Comgdrison (Washington: World
Bank, Staff Working Paper No. 359,
1979); Pasquale L. Scandizzo
and Colin Bruce, Mgethodologies
for Measuring Agricultural
Price
Intervention Effects (Washington:
World Bank, Staff Working Paper
No. 394, 1980); T.W. Schultz,
ed., Distortions of Agricultural
Incentives (Bloomington: Indiana
University Press, 1978); and
George S. Tolley, Vinod Thomas,
and Chung Ming Wong, AgEicultural
Price Policies and the Devel
oing Countries (Baltimore:
The Johns
Hopkins Press, for the World
Bank, 1982).
4. Willis L. Peterson, "International Farm Prices and the Social
Cost of Cheap Food Policies,"
American Journal of Agricultural

Economics 6
1(February 1979), pp. 12-21.
5. Marian E. Bond, "Agricultural Responses
to Prices in Sub-Saharan
African Countries," International Monetary Fund Staff PaR2CR

53
 30(December 1983), pp. 703-26.

6. Kevin M. Cleaver, The Impact of Price and Exchange Rate Policies

on Agriculture in Sub-Saharan Africa (Washington: World Bank,

Staff Working Paper No. 728, 1985), p. 6.

7. Ibid., p. 7.

8. See P.T. Bauer, "Regulated Wages in Under-developed Countries,"

in Philip D. Bradley, ed., The Public Stake in Union Power

(Charlottsville: University of Virginia Press, 1959), pp.

324-49; Simon Rottenberg, "Minimum Wages in Puerto Rico," in

Simon Rottenberg, ed., Thu Economics of Legal Minimum Wages

(Washington: American Enterprise Institute, 1981), pp. 327-339;

Vittorio Corbo, "The Impact of Minimum Wages on Industrial

Employment in Chile," ibid., pp. 340-56; Peter Gregory, "Legal

Minimum Wages as an Instrument of Social Policy in Less

Developed Countries, with Special Reference to Costa Rica,"

ibid., pp. 377-402.

9. See, for example, George J. Stigler, "The Economics of Minimum

Wage Legislation," American Economic Review 36(June 1946), pp.

358-65; Jacob Mincer, "Unemployment Effects of Minimum Wages,"

Journal of Political Economy 84(August 1976), part 2, pp.

687-6104.

10. Ramgopal Agarwala, Price Distortions and Growth in Developing

Countries (Washington: World Bank, Staff Working Paper No. 575,

1983), pp. 24-27.

11. Annual Report on Exchange Arrangements and Exchange Restrictions

1983 (Washington: International Monetary Fund, 1984).

12. Ronald I. McKinnon, Money and Caital in Economic Developgment

54
 (Washington: Brookings Institution, 1973), p. 134.
13. See Armeane M. Choksi, State Intervention in the

Industrialization of Develoging Countries: Selected Issues

(Washington: World Bank, Staff Working Paper
No. 341, 1979); and
World Develogment Report 1983, pp. 47-87. Of course, this is
the main reason why economists like Peter Bauer
have argued that
foreign aid, bzcause it is a government-to-
government transfer,
does so little to encourage development. See, for- example,
Bauer's Dissent on Devel.oament (Cambridge, MA:
Harvard
University Press, 1972). And the point about the essential

information generated by a competitive price

system has long

been associated with F.A. Hayek and other members

of the
Austrian School. See, for example, F.A. Hayek, "The Use of

Knowledge in Society," Aegri'an Economic Review 35

(September

1945), pp. 519-30.

14. See Russell C. Krueger, "U.S. International Transactions, First

Quarter 1985," Survey of Current Business 65(June 1985), pp.

34-71.

15. World Devel oment Report 1985 (New York: Oxford University

Press, for the World Bank, 1985), pp. 63-4.

16. K. Billerbeck and Y. Yasugi, Private Foreign Investment in

DeveloPng Countries (Washington: World Bank, Staff Working

Paper No. 348, 1979), p. 1.

17. Foreiga Private Investment in Develoging Countries (Washington:
International Monetary Fund, Occasional Paper 33, 1985).
18. Nicholas D. Kristof, "Curbs Give Way to Welcome For

Multinational Companies," New York Times (May 11, 1985), pp. 1,

55
 33.

19. Everett G. Martin, "U.S. Business Firms Don't Care to Provide

What Latins Need Most: Private Capital," Wall Street Journal

(June 25, 1965), p. 35.

20, ShailendrF J. Anjaria, Naheed Kirmani, and Arne B. Petersen,

Trade Policy Issues and Developments (Washington: International

Monetary Fund, Occasional Paper 3B, 1985), p. 79.

21. Donald B. Keesing, Trade Policy for Develoging Countries

(Washington: World Bank, Staff Working Paper No. 353, 1979), pp.

15-22.

22. Yung Whee Rhee, Bruce Ross-Larson, and Garry Pursell, Kgrea's

Competitive Edge (Baltimore: The Johns Hopkins Press, 1984).

23. Bela Belassa, "Exports and Economic Growth: Further Evidence,"

Journal of Development Economics 5(June 1978), pp. 181-89.

24. Michael Michaely, "Exports and Growth: An Empirical

Investigation," Journal of Development Economics 4(March 1977),

pp. 49-54; William Tyler, "Growth and Export Expansion in

Developing Countries: Some Empirical Evidence," Journal of

Development Economics 9(August 1981), pp. 121-30; and Bela

Belassa, "Adjustment Policies in Developing Countries: A

Reassessment," World Development 12(September 1984), pp. 955-72.

For a contrary view, see James Riedel, Trade as the Engine of

Growth in Developing Countries: A Reaggraisal (Washington: World

Bank, Staff Working Paper No. 555, 1983).

25. Bela Belassa et. al., DEyEloging Strategies in Semi-Industrial

Economies (Baltimore: The Johns Hopkins Press, for the World

Bank, 1982), p. 64.

56
26. See Interest Rate Policies in Develoaing
CggCies (Washington:
International Monetary Fund, Oc:asional
Paper 22, 1983),
27. Vito Tanzi, Inflation and the Personal Income Tax: An
International Perspective (New York: Cambridge University Press,

1980). See also Vito Tanzi, ed., Taxation, Inflation, and

Interest Rates (Washington: International Monetary Fund,
1984).
28. Ke-Young Chu and Andrew Feltenstein, "Relative
Price Distortions
and Inflation: The Case of Argentina, 1963-76," International
Monetary Fund Staff PaQes 25(September
1978), pp. 452-93.
29. See David J. Gould and Jose A. Amaro-Reyes,
to Effects of

Corruption on Administrative Performance

(Washington: World
Bank, Staff Working Paper No. 580, 1983).
See also World

Develogment Reort 1983, p. 117.

57
 CHAPTER IV

TAXATION, ECONOMIC GROWTH, AND DEMOCRACY

The object of this chapter is to set forth (1) the princi­

ples by which tax systems are evaluated,
(2) describe an ideal
tax system that maximizes incentives to
work, save, and invest,
thereby fostering growth, (3) examine the relationships between

the composition and rates of taxation with

macroeconomic measures
of growth, democracy, and civil liberties, and (4) provide a
detailed description of changes in marginal
tax rates and
thresholds for a sample of developing countries,
which reveals
the distinction between pro-growth and anti-growth
systems.

Principles of Taxation

Economists generally agree that sound tax

policy should aim
at certain goals. First, taxes should distort as little as

possible the prices resulting from the interaction

of supply and
demand in the market. Tax policy should strive for neutrality

between investment and consumption and among

products and
industries. Government should not use its power to alter
prices
to favor any one industry or producer.
To give but one example,
import duties protect domestic producers
from competition,
penalize consumers, and raise the costs
of inputs for exporters.
To achieve the goal of minimum price distortion,
it is
imperative to avoid high rates of taxation.
Historically, high
 customs duties have fostered smuggling.
Today, high tax rates
have brought a proliferation of tax shelters
to avoid taxation in
both developed and developing countries
as well as outright
evasion of taxes. High tax rates also erode incentives to
work,
save, and invest.

A tax is efficient if it brings minimal price

distortions.
An efficient system of taxation would
collect money without
seriously influencing individual decisions
on how much to work
and to save and where to invest. It would not discourage people

who put in longer hours to earn more

income. It would not reward
borrowing and penalize savings. It would not tax savings twice-­

once when the money is earned and again

when the money earns a
return. An efficient system would not be riddled
with exemp­
tions, deductions, and credits that direct
money to investments
with lower tax liabilities instead of
to investments that

increase real output at the highest rates

of return.
A second important standard against which
to evaluate
systems of taxation is equity or fairness.
Historically, equity
has always meant equal treatment of equals. To discriminate
against equal classes of taxpayers would
be regarded as arbi­
trary, capricious, and generally wrong.
So, for example, if two
families earn identical incomes, this doctrine of equity would

imply that each should contribute identical

shares in taxation.

Of course, unusual circumstances might

dictate different
treatment of the two families in this example. A wise tax system
might want to reduce the tax burden of
the family that incurred

59
heavy medical expenditures, suffered the ravages of storm damage,

bore costs to move to a new job, and so on. But the idea that

different rates of taxation would be applied to taxpayers in

similar circumstances violates the norm of equity.

Until recent times, equity meant "horizontal equity," that

is, people in similar economic circumstances should bear similar

tax burdens. A uniform, or proportional, tax meets the norm of

horizontal equity. Every taxpayer bears taxes in direct propor­

tion to his income. As incomes double, triple, or grow tenfold,

tax obligations increase at the same rate. In short, equity

meant that all income should be treated equally as part of the

tax base, and people with the same income should pay the same

tax.

The advent of the Great Depression and the accompanying

dramatic growth qf social programs in the Western industrial

democracies brought a new dimension to the concept of equity.

"Ability to pay," or "vertical equity," gradually became regarded

as a hallmark of sound tax policy. Underpinning vertical equity

was the idea that fiscal policy could be a tool for redistri­

buting income. Taxing incomes at progressively higher rates

would enable the government to brir' about greater equality in

the distribution of after-tax income.

In developing countries, taxing higher incomes at steeper

rates also meant that the government could tap its more pros­

perous subjects to finance national development projects. High

rates of taxation are believed to be one means of financing
government directed capital formation.

In the view of vertical equity, fairness means that high­

income earners should pay higher fractions of their incomes in

taxes than low-income earners. The most aggressive application

of this prin':iples typically uses of system of graduated tax

rates applied to an individual income tax, in which additional

chunks of income are taxed at steadily higher and higher rates.

But the vertical equity norm has often failed in practice.

In most countries tjith graduated tax rate schemes, wealthy

citizens often utilize tax avoidance or evasion techniques that

reduce total income to a very modest level of taxable income.

These loopholes have sprung up becaus_ wealthy taxpayers are

reluctant to hand over 70, 80, or even more than 90 percent of

their additional earnings beyond a certain level. Application of

a pure vertical equity norm would preclude such loopholes to

insure that those who can afford to pay more do so.

The explosive growth of tax expenditure items, tax shelters,

and outright evasion in the United States and other advanced

countries has introduced serious inefficiencies into these

economies. Over the past two decades, it would appear that

opinion has shifted toward less progressivity in tax rates and

more concern with the disincentives of high taxes. Another way

of putting this is that considerations of efficiency have begun

to take on higher priority than the vertical equity notion of

fairness and concerns over the distribution of the tax burden; as

will, economists and international lending institutions have

61
 reported that state-directed
efforts at capital formation
have
often produced politically-motivated
"white elephants" which
make
little or no economic sense.
The original concept of
horizontal
equity is increasingly
recognized as more consonant
with the tax
policy goal of minimizing
price distortions and
maximizing
efficiency than is the
post-depression concept
of vertical equity
or ability to pay. This transformation in
thinking reflects the
increasing influence of
the supply-side revolution.
Efficiency and equity are
only two of the standards
by which
we can evaluate tax systvms.
Yet another is sinplicity.
The
notion of simplicity encompasses
the comprehensibility of
the
system, the ease with which
taxpayers can figure out
how much
they owe, and how much
time and effort it takes
to comply with
the system. Woven into
simplicity, especially
in the less
developed countries, is
administrative workability,
which
includes the need For trained,
honest personnel, literate
taxpayers, and the costs
of collecting revenue.
It does little
good for any government's
revenue agents to spend
$1.01 to
co .ect $1.00 in taxes.
It is a lot cheaper to
increase compli­
ance and tax collections
by adopting a simple system
than by
hiring thousands of revenue
officials to enforce a
complicated
or cumbersome system.
In general, low rates minimize
the
incentives to engage in
tax avoidance or evasion
schemes; high
rates foster tax-reducing
behavior, thereby reducing
efficiency.
To summarize, we can evaluate
tax systems on the basis
of
their efficiency, equity,
simplicity, and administrative
worka­

62
 bility.' Efficiency is a tried and
tested concept in economics.
It means maximizing the
satisfaction that citizens
derived from
the economy. It requires neutrality between
production and
consumption, and among products
and industries. It means that
government should remove
as few resources from the
economy
as possible to pay for the
legitimate activities of
government.
The reason is that resources
in private hands are used
more
efficiently in producing
goods and services than
the same
resources placed in public
hands. In general, governments
do not
stress profit-maximizing
activity nor do government
enterprises
have to meet the competitive
test of the market to stay
in
business. Thus tax burdens shoud be
as low as possible.
Equity is a normative standard
that stipulates the appro­
priate distribution of the
tax burden by income classes,
with the
recent emphasis on vertical
equity coming under growing
disen­
chantment due to the disincentive
effects of high rates of
taxation. Simplicity is an intuitive
notion that encompasses
the
comprehensibility of the
tax system, the taxpayers'
certainty of
the amount of taxes owed,
the costs of compliance,
the public's
willingness to pay, and
the ability to meet tax
obligations
without costly, expert assistance.

An Ideal Tax System

An ideal
tax system would be designed
to meet six require­
ments that are compatible
with maintaining an externally
competi­

63
 tive orientation and free-enterprise economy.

The first requirement is to generate sufficient revenue

to
finance a major part of overall public expenditure and maintain

fiscal reserves at a satisfactory level. (Deficits and public

debt should be shunned in favor of surpluses and accumulated

reserves.)

The second requirement is that the tax system remain

neutral
towards the internal cost/price structure, the supply
of human
effort, and private investment decisions (which means, in effect,

that the emphasis should be on proportionality apart from

a
modest degree of progressivity on personal taxation to
leave the

poorest classes untouched by direct taxation).

The third requirement is that the laws governing the tax

system be revised from time to time to make them consistent

with

changing commercial practices.

The fourth requirement is that each and every levy--direct

or indirect--be simple and easy (and, therefore, inexpensive) to

administer and does not encouraoe evasion. A tax system with low

rates of charge cannot afford to finance costly overheads.

The fifth requirement is that the tax system be equitable

(which, in practice, means setting relatively high thresholds

for
personal taxation, which exempts those on the lower end of the
income spectrum, leaving them virtuaily untouched by direct

taxation).

The sixth requirement is that the tax system be only

exceptionally used to acheve non-fiscal objectives. Such policy

64
 objectives should be pursued directly
through public expenditure
programs and by appropriate legislative
measures, and not
indirectly by adjustments to tax
rates and amendments to tax
laws. Once a government starts to tread
the path of using the
tax system to pursue economic and
social policies, the conse­
quences are unpredictable, usually
irreversible, and the costs

unquantifiable.

The Case of Hong Kong as an Ideal Tax System

To begin with, Hong Kong is a duty-free

port. There is no
general tariff on goods entering
Hong Kong but duties are charged

on four groups of commodities--alcoholic

liquors, tobacco,
certain hydrocarbon oils and methyl
alcohol--irrespective of
whether they are imported or manufactured
locally. Duties are
set at either percentage ad valorem
rates (on Western beverages)
or item-specific rates pe-- litre or
kilogram.
Rates are levied on -he occupation of landed property at a
percentage of the assessed rateable
value, which is defined
as the annual rent at which the
property might reasonably be
expected to be rented. New valuation lists are prepared
periodi­
cally. General rates approximate 5.5 percent
of rateable
values, which covers both general
and sjecifically urban service
rates. Educational, charitable, and welfare organizations
may be
exempted.

Apart from general rates, indirect taxes include excise

65
 duties, bets and sweeps taxes, stamp duties,
entertainment tax
and hotel accommodation tax, motor vehicle
taxes, franchises and
airport concessions. Betting duty is imposed on bets on author­

i..ed totalizators (horse racing) at 15 percent and lotteries at

30 percent. Entertainment tax on the price of admission to

cinemas averages 9 percent and 30 percent
for race meetings.
The hotel accommodation tax is 5 percent of the expenditure on
accommodation by hotel guests. The stamp duties are fixed or ad
valorem on different classes of documents
relating to assignments
of immovable property, leases, and share
transfers.
Direct taxes are defined as earnings and
profits taxes and
estate taxes. These are levied under the Inland Revenue Ordi­
nance. Hong Kong has a schedular system of taxation
whereby
persons liable are assessed and required
to account for tax on
four separate and distinct sources of
income: business profits,
salaries, property, and interest. At the taxpayers option, all
income can be aggregated to take account
of a substantial
personal allowance. The standard rate of tax, viz., the top
applicable rate on the last dollar earned,
v.as increased from 15
to 17 percent on April 1, 1984. (The rate stood at 12.5 percent

until 1966, when it was raised to 15 percent.)

Profits tax is charged only on profits arising in,

or
derived from, Hong Kong from a trade,
profession or business
carried on in Hong Kong. Profits of unincorporated businesses

are taxed at 17 percent whereas profits of corporations are taxed

at 18.5 percent. Profits assessable to profits tax are
net

66
 profits, which permits the deduction of all expenses
incurred in
the production of assessable profits, along with charitable

donations equivalent to 10 percent of nat assessable profits.

There is no withholding tax on dividends paid by corporations,

and dividends received from corporations are exempt.

There is no capital gains tax in Hong Kong.

Salaries tax is charged on payments arising in, or derived

from, Hong Kong. Tax payment is calculated on a sliding scale

which varies from 5 to 25 percent on HK$10,000 segments

of income
(that is, income after deduction of substantial personal allow­

ances. These allowances are so substantial that a family of four

does not pay income tax unless it earns more than LJS$11,000.

Moreover, 13,000 taxpayers, about 6 percent of the total number

in the tax net, contributed over half the total yields

from the
salary tax in 1982, despite the low rate). But the overall
effective rate is restricted to a maximum of 17 percent of gross

income.

Property tax is charged on the owner of land or buildings in

Hong Kong at the standard rate of 17 percent on the actual rent

received, less an allwance of 20 percent for repairs
and

maintenance.
"To maintain external competitiveness
with Singapore's

growing financial center, interest tax on foreign currency

deposits was repealed on February 24, 1982. The rate of tax on

interest in Hong Kong currency was reduced from 15
to 10 percent

in 1982, and repealed on October 16, 1983.

67
 Estate duty tax ranges from 10-18 percent, with an exemption

on the first HK$2 million.

Business registration fees consist of an annual registration

charge of HK$350, but small businesses may be exempted.

Other revenue arises from taxes on the registration of motor

vehicles, fines, forfeitures and penalties, royalties and

concessions (e.g., rental sites at the airport), gcvernment

utilities, and a wide range of fees and charges (marriage

licenses, birth records, passports, etc.)

Sales of long-term leases on Crown land (all land in Hong

Kong is owned by the Crown) provide a modest proportion of

overall revenue. Land sales have varied enormously over Hong

Kong's postwar history, reflecting relative swings in the

business cycle and political confidence. Ordinarily, they supply

less than 10 percent of total receipts, but the boom years of the

late 1970s generated receipts that constituted as much as

one-third of overall revenue, thus contributing to the terri­

tory's large reserves during 1976-1981.

Direct taxes have played an increasingly important role in

financing government outlays as Hong Kong's economy has matured.

There will be a tendency for the relative importance of earnings

and profits taxes to increase because there is a greater scope

for altering the structure of the direct tax system and the

applicable rates. In the case of indirect taxes and fees and

charges, there are obvious constraints. As earnings and profits

taxes are roughly ."roportional to incomes, yields are related to

68
 the growth rate of the
economy, which, if sustained
at high
rates, generates high
yields. In other words, yields
from
earnings and profits taxes
are fairly income-sensitive,
while
yields from indirect taxes-,
fees and charges are relatively

income-insensitive.
To illustrate this point,
yields from earnings and
profits
taxes grew from HK$52
million in 1951-52 to
$929 million in
1971-72, to HK$5,880 in
1979-80, to HK$13,343
million for 1934­
85. The yield has increased
at a much greater rate
than the
gross domestic product,
despite a relatively constant
flat rate
on both individual (15
percent) and corporate
earnings (which was
increased from 15 to 17
percent in the late 19 7
0s). During the
1970s, the tax yield increased
seven and a half times
while the
gross domestic product
increased four and a half
times. The
reason is that sustained
high rates of Economic
growth have
sharply increased the
tax base and the number
of individuals and
firms liable to direct
taxation. In the fledgling state
of its
economic transformation,
the earnings and profits
taxes generated
small sums; however, the
maintenance of low tax
rates stimulated
investment and growth
which has repaid the public
sector with a
positively elastic supply
of receipts. During the 1970s, for
example, the yields from
earnings and profits taxes
grew at an
average annual rate of
25 percent, while the
annual growth in
indirect taxes was 15
percent and that from
fees and charges only
17 percent. Thus during the 19 7 0s,
the contribution from
indirect taxes fell from
39 to 28 percent, fees
and charges

69
 fell from 31 to 27 percent, while that from direct
taxes rose

from 30 to 45 percent.

No distinction is made between residents and non-residents

for purposes of taxation. Hong Kong citizens and foreigners are

subject to the same rates and types of taxation.

Nor does Hong Kong offer any special concessions to overseas

investors that are unavailable to local residents.
Hong Kong

does not provide specific investment incentives by type of

industry or level of investment; rather, it tries to maintain an

attractive overall investment climate.

The Hong Kong government is concerned to minimize

dependence
on any one source of revenue and thus tries to maintain
yields
from indirect taxes and fees and charges, lest upward
pressure be

put on direct tax rates to the detriment of incentives to work,

save and invest. In particular, the government adheres to the

principle that general taxation should not assist in the finan­

cing of services which can be related to individual needs except

in unusual circumstances. In general, fees and charges should be

designed to cover the full cost (including the cost of capital)

of the services provided, though, on occasion, some

are pitched

deliberately at a level to deter usage for policy reasons.

Especially in the case of public utility undertakings

(railroads,
waterworks, postal services, the airport, tunnels, etc.) the
basic principle of pricing policy must be that consumers
should
be charged the full cost of the resources consumed by each

undertaking, unless conscious policy decisions dictate

otherwise

70
 on social or political grounds.

The Hong Kong government does not

employ any means of
compulsory procurement of agricultural
or industrial goods at
below-market prices and thus imposes
no implicit tax on Hong Kong

producers.

Since the territory maintains

a monetary system that is
linked to the U.S. dollar at a
fixed rate of US$1=HK$7.80, in
which the issue of domestic banknotes
requires one hundred
percent cover in U.S. currency,
the Hong Kong dollar is literally
the U.S. dollar one step removed
at a denomination of 7.80.
Since the United States is Hong
Kongs chief trading partner, it
makes sense for a small externally-dependent
territory like Hong
Kong to link its currency with that
of its main trading partner.
The Hong Kong money supply expands
and contracts in consequence
of the overall balance of payments, which reflects the competi­

tive of Hong Kong goods on world

markets and capital inflows, and
is thus neither over- nor undervalued
for any substantial period
of time. Neither exporters nor importers
are taxed or subsidized

through an incorrectly-valued exchange rate.

The Relationship between Taxation,

Growth, and Democracy

Analysts of American and European

taxation and economic
activities confront a wealth of
generally reliable data on
national income accounts, tax systems, labor
force participation,
industrial and agricultural output, and so forth. The same is

71
not true for analysts of less developed countries (LDCs).

Students of LDCs have to patch together data, often incomplete,

unreliable, or downright inaccurate, from a variety of private

and public international sources. The two most '.elpful, and

frequently consulted, sources are "World Development Indicators,"

published annually by the World Bank, and "Government Finance

Statistics" and "International Financial Statistics," published

monthly and annually by the International Monetary Fund. But

mixing and matching these two sources into one unified data fiiL,

is not entirely straightforward. The IMF roster of countries

numbers 104, but the World Bank indicators are available for only

98. The gap of 6 is compounded by some non-overlapping; the

British Crown Colony of Hong Kong, for example, is not a member

of the IMF and its financial stAtistics are not published in IMF

bulletins, whereas Hong Kong's development indicators appear in

World Bank publications. Only a few basic indicators appear in

World Bank tables for small countries with populations under one

million.

Even this picture overdramatizes the availability of data on

LDCs. Among the 104 count-ies for which the IMF publishes

financial statistics, complete national income accounts exist for

only 57 of these.' While the percent of public receipts col­

lected in the different forms of taxation is available for 104

countries, analyzing taxation as a share of gross national

product is confined to 57. But the timing of IMF financial

statistics ranges from as recent as last year to as far back as

72
 1978 or 1979 for some countries. Many African nations are slow

to get their financial statistical houses in order.

Neither the World Bank or the IMF releases
detailed informa­
tion on the structures of their
member countries' tax systems.
Thus, details on the rates of direct
and indirect taxation, along
with exemptions, deductions, credits,
special incentives, and
other features of taxation, must
be culled from other sources.
For information dating from 1975, the
most readily accessible
data appear in the publications
of two commerical international
tax service organizations. Beginning in 1975, with updates
in
1977, 1979, 1981, 1982, 1984, and 1985, Price Waterhouse
has
published the structure of tax rates and tax brackets for
individual income taxes in those countries in
which it maintains
offices. The list has expanded from 80 to
94 countries during
the past decade. Price Waterhouse also publishes an
extensive
series of "Information Guides" about many countries
that are
periodically updated, which contain
information about other
aspects of taxation, business regulations, and
economic condi­
tions. In 1982, with revisions in 1984,
Coopers & Lybrand
published a competitive volume.
When colonies and dependent
territories from the joint listing
of 104 separate taxing
entities are eliminated, only 77
countries remain, many of
which are mini-states of little
consequence. Quite a few of the

77 are oil-exporting nations that

rely solely on oil proceeds for

revenue, imposing no individual income taxes.

Data on individual and corporate income taxes are much
more

73
 inaccessible before 1975. The best source is an annual series
published by Great Britain's Inland Revenue Department
between
1956 and 1973 that contains annual tax specifics for approxi­

mately 40 countries between 1956 and 1973. The early volumes

were titled Income Taxes in the Commonwealth and Income Taxes

Outside the Commonwealth (1958-1966), and the successor series

combined both into one annual volume titled Income Taxes Outside

the United Kingdom (1966-1973).2 Comparable data on overseas

French and Dutch territories are not readily available.

Nor are
data on Latin American nations before 1975 suitably
published in
one convenient source. To assemble these data requires the

scrutiny of legislation on a country-by-country basis, which no

clearing house has yet assembled on a historical basis. The

International Bureau of Fiscal Documentation in Amsterdam

publishes current information on explicit taxes for

all regions
of the world and maintains an extensive library, but
its histor­
ical collections are sporadic and incomplete. As a result,
attempts to link long-run changes in effective marginal
tax rates
on individuals, and effective rates of tax on businesses,

industries, and economic sectors tu indicators of

economic
performance cannot encompass the entire developing
world and are
severely restricted by the paucity of longitudinal data to the

most recent decade (1975-85).

More data is available for economically important

and
heavily populated countries. But several of the poorest nations
in the world are economically unimportant and lightly
populated.

74
 Neither Price Waterhouse
nor Coopers & Lybrand maintain
an
overseas office or local
correspondent in those developing
coun­
tries with the least attractive
business opportunities.
The
absence of data on these
countries systematically
biasses the
available data in favor
of the better performing
economies. We
are simply unable to analyze
the countries with the least
attractive business climates.
Thus attempts at fully comprehen­
sive studies of the developing
world systematically exclude
the
least well off nations that
may be most in need of policy
reform
to stimulate economic growth.

No study of the political economy of dvelopment would be

complete without an attempt
to link economic and tax
policies and
various measures of economic
perfcrmance to measures
of indivi­
dual freedom and political
systems. Apart from recognizing that
political stability is important tc
the process of economic
development, since investors
are scared away by chronic
insta­
bility, development economists
possess neither the training
nor
inclination to investigate
the relationships between
those purely
economic factors influencing
developing (investment ratios,
exchange rates, important
restrictions, tax incentives,
price
controls, etc.) and political
factors or the political
conse­
quences of success or failure
of development. Conversely,
political scientists and
other non-economists often
overlook the
economic dimensions of the
processes of development.
If sustained economic growth
has no effect on the evolution
of democratic institutions
or civil liberties, or indeed
if

75
 overly rapid rates of growth engendered
totalitarian regimes that
repressed individual freedoms, then
the political consequences of
growth policies would require serious
reconsideration. On the
other hand, if a necessary condition
of democracy and improving
individual liberties was high growth, policies
that fostered
prosperity would also nurture free institutions
and individual
rights. Fortunately, data on political freedoms,
civil. rights,
and democratic institutions are routinely
published in the annual
January-February issue of Freedom House,
thereby allowing us to
test the relationship between pclitical
and economic liberties.
Freedom House ranks virtually all nationz of the world by civil

liberties and political rights on a

seven-point scale from "most

free," a score of 1, to "partly free," (3-5) to "not free," a

score of 7. Pclitical rights range from the presence
of a fully
competitive electoral process, to a
limited role for opposition
parties within a predominantly one-party
state, to the complete
absence of free elections where despots
rule unconstrained by
public opinion or popular tradition.
Civil liberties encompass
freedom of the press, court protection
of the individual, free
expression of personal opinion, and free choice in occupation,

education, religion, residence, and

so on, to the other extreme
of pervading fear, little independent expression even
in private,
and swift imprisonment and execution
by a police-state.

Freedom House also displays a continuum

of political
systems, in which it classifies countries
as multiparty, dominant
party, one-party, military non-party,
and nonmilitary non-party.

76
 However, the organization
provides no comparable concept,
measure, or ranking of economic
liberties that might be compared
with political rights or
civil liberties. Thus, the analyst
would have to develop indicators
(absence of wage and price
controls, free movement of
labor and capital, lack of
exchange
controls, monetary stability,
proprietary rights, free
entry and
exit in every industry, absence
of state monopolies for procure­
ment or distribution, neutral
tax systems, etc.) and assemble
the
requisite data to score each
country on overall economic
liberty.
A complete analysis of developing
countries must, therefore,
encompass both economic and
political determinants as
well as the
political consequences.
Economic development does
not occur in a
political vacuum; rather,
it does or does not take
place within a
sovereign political entity
that maintains specific institutions
of gove-nment that foster
or suppress political freedoms
and
civil liberties. It is important to know whether
growth, the
chief indicator of development,
is correlated with the spread
of
democratic institutions and
individual freedoms.
Within the four-month time
frame in which this report
has
been prepared, we have assembled
information on a large number
of
economic and political variables
(see the list attached to
the
end of thi - chapter). These includes such standard
measures as
tax shares of gross national
product, the composition
o.- taxes,
top marginal rates and thresholds
of the individual income
tax,
long-term annual average
changes in exports, imports,
investment,
public and private consumption,
industrial and agricultural

77
 output, public and external debt, and several political indica­
tors. A full list of significant bivariate relationships is

presented, and several of the most important scatterplots

are
reproduced in the text. To glean those that remain significant

in multivariate analysis, the stepwise method of

multiple

regression was employed.

It is important to mention that the kinds of data

on
implicit taxes that we have argued are important,
pe.haps more
important than explicit, direct taxes, in affecting
growth and
development are even more difficult to obtain than
evidence on
changing tax rates over time. Precise, statistica' information

on farmgate prices is atailable only on a sporadic,

case-by-case

basis (see the data in Chapter III). Therefore, it is not

possible to test in a cross-sectional regression

the relative
importance of the farmgate-price tax compared with the personal

or corporate profits tax. Another crucial implicit tax on

exporters (and subsidy, or tax expenditure, for importers)
is the
extent of exchange-rate overvaluation, for which
quantitative
estimates may be available only in the confidential
files of the
International Monetary Fund. The World Bank's preliminary study

of exchange rate distortions for 31 countries show

only 12 with
medium or high distortions, which limits the ability
to include
these data in multivariate analyses encompassing
between 50-100
developing countries. Limttations of time precluded assembling

comprehensive data on tax incentives for foreign

and/or domestic
investors that could have been entered into a comprehensive
model
 for testing. (See Chapter V for selected illustrations
of tax
incentives that have proven successful
in LDCs.)
Two other potentialiy important
variables are ie exten to
which the tax laws are enforced (compliance) and the extent to
which the presence of an underground
economy vitiates the
disincentive effects of statutory
systems of taxation. Data
on these are virtually non-existant.
Indeed, the overriding
difficulty in analyzing taxation
and development is the lack of
data by which hypotheses can be
tested. Thus, much future work
remains to augment the preliminary
start we have made in assess­
ing the quantitative relationships
between the different elements
of taxation and development.
An important aspect of future
work
must be the extent to which one
counterproductive dimension in
a
tax code is a proxy for an entire
system of explicit and implicit
taxation that retards growth.
It is also important to know to
what extent a olicy reform in one dimension
of taxation, e.g.,
lowering high marginal rates and increasing thesholds,
might have
an effect on growth with no concurrent
changes in other dimen­
sions of tax or overall economic
policy. To this end, we have
made some preliminary attempts
to relate individual income tax

rates with a variety of macroeconomic

indicators.
All tables appear at the end of this
chapter. The presenta­
tions include a legend describing
the variables used in the
analyses, a summary list of statistically
significant bivariate
relationships (with correlation
coefficients), selected scatter­
plots of interesting results,
a list of multiple regression

79
tables, and a list of every LDC in the analysis file.

Findings

As previously mentioned, the absence of national income

accounts limits any analysis of aggregate tax burdens as a share

of national income with other variables to half or fewer of the

LDCs, which may misrepresent the total pattern in the developing

world. The more sophisticated countries are most likely to be

able to assemble the data required for a system of national

income accounts. Thus any conclusions about overall levels of

taxation exclude about half of all LDCs, especially the least

well off. For theoretical reasons, we would expect that the

structure and rates of taxation would be more important than

aggregate burdens of taxation in affecting develoment. A low tax

rate that generated a high level of aggregate receipts, for

example, would be more conducive to growth than a high tax rate

system that produced little actual revenue, but discouraged a

considerable economic activity.

The analysis shows that taxation as a share of gross

national product positively influences the level of government

expenditure (r=.408). This is because taxes and borrowing are

the foundations of public spending. Aggregate tax levels

negatively affect the annual growth rate of agricultural outpu: ­

(r=-.49). Figure 1 displays the plot of taxation as a share of

GNP with the prior 22 years average anniual economic growth rate

60
 (on a per capita basis). The simple correlation is .274
at a
significance level of .028 for 49 plotted values, just
less than
half of the countries in the data
file. High growth countries,
whose sustained growth has brought
a measure of prosperity, have
relatively larger aggregate tax
burdens than slow growth coun­
tries. They depend more on industry than
on agriculture. It
would be unwarranted to infer growth
from high aggregate taxa­
tion. Rather, as countries prosper, their
governments succeed in
taking away a higher percentage
of national income in taxes,
which has been the experience of
the Western industrial demo­
cracies. Greater prosperity and larger public
sectors go hand in
hand in the developed world; the same finding applies among
the
developing countries. But in the developing world, larger
public
sectors may reflect l&rger aggregate
tax burdens, not necessarily
higher rates of tax on individuals,
corporations, and commo­
dities. For example, Hong Kong's aggregate
tax burden is higher
than many LDCs, even thoughts its
rates of tax are the lowest.
The overall level of taxation is not significantly linked
with high or low rankings on political or civil
liberties,
although a slightly higher fraction
of high-tax countries rank
better on political rights. This, too, reflects the slight
positive association between growth,
prosperity, and the gradual
unfolding of political rights in
better performing economies.
Remember, the previous analysis
applies to the fewer than
half of LDCs for which full national
income accounts are vail­
able. The universe of LDCs expands to
over 100 when the analysis

61
moves from aggregate tax levels to the composition of taxes.

Loot-ing first at the share of receipts collected from direct

taxes, greater dependence on direct taxes (individual income

taxes, corporate taxes, social insurance contributions, and

property taxes) is positively related to overall economic growth

(see Figure 2), the growth of private consumption, per capita

income, and th2 level of public spending. Rich, high-growth

countries collect a higher- share of receipts in the form of

direct taxes than poor countries. They have developed an

urbanized, industrial, commercial economy on which direct taxes

can be imposed (though, as shown later, the tax rates matter). 3

Indeed, as dependence on indirect taxes rises, countries

fare less well in their annual growth rates of imports (see

Figure 3), investment, i.ndustry, overall economic growth (see
Figure 4), and, consequently, private consumption and per capita

income. Most of this adverse effect is due to the application of

international trade taxes, not domestic excises or sales taxes.

Most LDCs are heavily dependent on exports and imports. The

correlation between per capita income and international trade
taxes, for example, is -. 415. What is lacking in our analysis is

data, on a country-by-country basis, that would enable us to

examine the specifics of indirect taxes and their impact on the

separate agricultural and export sectors. One hypothesis is that

overreliance on indirect taxes may retard export-led growth

From
either the industrial or agricultural sectors. It is possible to

simultaneously have an overall low aggregate tax burden that

82
 relies disproportionately on indirect levies which takes the form

of very high customs or export duties on a few key inputs, crops

or commodities, thus retarding the advance of those sectors.

This situation aptly describes the experience of many African

nations with predominantly rural economies.

To the extent that the system of taxation and the structues

of tax rates influence economic growth, taxation indirectly

affects the prospects for individual liberty in the LDCs.

In general, countries with sustained low growth earn negative

ratings on political rights and civil liberties; high growth

countries, especially above 4 percent, show an even distribution

(see Tables 1 and 2). High growth is not a sufficient conditio­

of individual liberties, but appears to be a necessary condition

for the gradual emergence of political and civil rights.

Similarly, Tables 3 and 4 show that countries with low per capita

incomes, the results of decades of slow growth (not necessarily

low starting points, since even the high-growth Pacific Rim

economies began their postwar ascent with per capita incomes

below $200), fare badly on political rights and civil liberties.

The leaders of the economic basket cases of the world inflict the

greatest political deprivations on their subjects.

Growth profoundly affects living standards and the prospects

that countries will evolve democratic institutions and a concern

for individual rights. Growth correlates positively with greater

dependence on direct taxation and negatively with indirect

taxation (as shares of total receipts, not as rates of taxation

83
applied to different economic activities). When growth is

regressed against eight potentially influential variables, those

that surface as statistically significant are the annual growth

rate of investment and the level of direct taxation (see TAble

5). The growth of imports, exports, the level of indirect

taxation, and the size of externally-held public debt are

insignificant.

Before leaving the theme of direct taxation, it is worth­

while to remember the supply-side thesis that incentives,

especially the level of marginal tax rates, influence decisions

on work, saving, and investment. Table 6 groups countries by top

marginal rates and tax brackets at which these rates apply.

t7.ntries fall within nine possible classifications, from high to

i*-ir+ to low top marginal rate, and similarly for high, medium,

low thresholds of income at which the top rate takes hold.

Only one country, Hong Kong, maintains a low top marginal tax

ra-e. It also enjoys the highest growth rate in per capita

income. Countries with high thresholds enjoy consistently higher

growth than those with low thresholds. For medium tax rate, high

threshold countries, the average is 4.5 percent; for high tax

rate, high threshold countries, the average is 3.9 percent. Even

the high rate, medium threshhold countries average 3.1 percent.

This point is worth belaboring. So long as high top

marginal rates do not apply to more than 99 percent of a coun­

try's population, it does not inhibit human endeavor on a

wide scale. No individual is deterred from moving out of the

RA
 subsistence sector into the cash
economy by the disincentive of
high marginal rates of tax on
low cash incomes. The effective
marginal tax rate for the overwhelming
majority of the economi­
cally active population remains
low. Even at the medium thes­
hold, between $20,000 and $50,000,
most taxpayers face effective
low rates. It is the low threshold countries,
where the top
marginal rates take hold at very
low incomes for professional,
skilled, mobile, middle and upper-middle
class populations, that
show the worst performance. Even if only a small proportion
of a
country's population are caught
in the income tax net, that small
fraction is the human engine that
drives growth through decisions
to invest, work, save, or shift
money and human capital abroad

and substitute leisure for effort.

People, like commodities and capital,

can be viewed as
internationally tradeable or transferable.
Individuals export
their talents as well as their capital. For those residents of
developing countries who possess
highly valued skills in demand
:n other countries, they may be
tempted to migrate to earn higher
aftertax returns on their human
capital. Therefore, to compare
the earnings of this small, but
important, minority of indivi­
duals who provide entrepreneurial,
technical, professional, and
other skills and services as a
multiple of per capita income
in
their own countries is potentially
misleading as an indicator of
their economic well-being and
incentives. Even if a Pakistani,
Indian, Jamaican, Briton, or other
foreign resident enjoys a
relatively high income in his
own country, he may still migrate

85
to another country in which the application of his skills or

talent provides a sharply higher aftertax real income, and,

units
equally important, a lower top marginal rate on incremental

of output.

Bangladesh, Ghana, Jamaica, and several East African nations

show especially dismal economic performance. The high rate, low

threshold average for 7: countries is 1.9 percent, and this

grouping includes many of the economic basket cases of the

world. Even moderate top marginal rates that take effect at

relatively low incomes have a stultifying effect on growth.

When the last category is further refined to include all

tax rates
those with thresholds below $10,000, or with marginal
and
: qeding 70% when the thresholds falls between $10,000
The
:-'0, 00, the average growth rate falls to 0.8 percent.

, urt ten countries that remain in that refined classification

irludes four with negative growth and only three with average

annual growth rates exceeding 2 percent.

Per capita income for 63 developing countries is negatively

(r=-.443,
correlated with increases in top marginal tax rates

significance=.O00). In other words, the poorest countries of the

taxes with
world consistenly show systems of individual income

the highest marginal rates. A consistent pattern emerges for per

the lower the

capita income and tax thresholds for the top rate:
the smaller is per
threshold at which the top rate takes effect,
6
capita income (r=.26, sig.=.02 ).

Finally, the marginal tax rate correlates negatively with

o'L
 the size of the budget surplus/deficit
as a percentage of gross
national product. Countries with lower rates
have balanced
budgets or modest deficits;
countries with the highest
top rates
also run the largest deficits.
The correct inference to
be drawn
is that budget deficits
persist because of high
tax rates, not
despite them. Attempts to reduce budget
deficits by imposing
higher tax rates sLems counterproductive.

A cursory examination of
corporate tax rates shows
a large
measure of uniformity throughout
the developing world. The
analysis reveals no statistically
significant patterns relating
corporate tax rates with
per capita income, economic
growth,
macroeconomic trends, or
political variables. A
more complete
analysis of the effect of
corporate taxes on development
would
have to take into account
depreciation schedules,
investment
credits, provisions for
special deductions against
foreign
exchange losses, bad debts,
and so forth. Given the widespread
variability of these factors
affecting actual corporate
tax
liabilities, it is somewhat
surprising that statutory
rates are
so uniform. The relatively greater mobility
of capital (compared
with property or labfir)
may induce uniformity in
treatment of
corporate taxes.
Tc what extent do the relative
shares of receipts collected
in the form of direct and
indirect taxes affect the
growth rates
of imports, exports, private
consumption, government
spending,
and external public debt?
The regressions separate
sign ficant
from insignificant factors
in examining these trends
(see Tables

87
 7-11). Imports are dominated by the growth rate of investments

and exports; the level of public spending is largely affected by

the size of tax receipts (though the overall R

square is only
.166); taxes have no apparent effect on the size of external

public debt; the growth of industry affects the growth rate

of exports; and, overall economic growth dictates

the rise in
public consumption. It is important to keep in mind that these

statistical relationships measure the shares of

receipts col­
lected in the specific forms of direct or indirect
taxation; they
do not reflect the rates of taxation that may
apply to any form
of economic activity, any specific sector of the
economy, or on
particular exports or imports. Knowledge of rates, which
determine after-tax rates of return to economic
activity, is th
ey to understanding the impact of direct and indirect
ta:ai.

,n economic perfo-mance.

Apart from the overall rate of economic growth,

other
indicators of macroeconomic performance are not
significantly
correlated with political rights or civil liberties. However,
the structure of the political system, as might
be expected,
influences the presence of political rights and/or
civil liber­
ties (see Tables 12 and 13). Multiparty democracies foster
liberty; one--party states and non-party authoritarian regimes

inhibit liberty. Competitive democracies do somewhat better on

growth rates and levels of per capita income (See Tables 14 and
15). Or, put differently, high-growth, high-income
nations are
more likely to evolve competitive party, democratic
systems of

88
 government. Growth, which leads to rising
prosperity, is a
necessary but not sufficient
condition of democratic institutions
and individual freedoms. Stagnation, which breeds poverty,
is almost a sufficient condition
for authoritarian governments,
political repression, and the
denial of civil liberties.
A
humanist view of the developing
world absolutely dictates the
application of growth-oriented
economic policies.

Trends in Individual Income Taxes

Richard Goode has noted that

in many developing countries
the top marginal rate may be
too high.' He favors an initial
statutoory marginal rate of
at least 6 to 10 percent to
repay the
cost of assessment and collection.
The presence of personal
exemptions in virtually every
system of individual income
taxes
means that the effective tax
rate will be much lower for
those
subject only to the initial
statutory rate.
Low tax rates introduce minimal
distortions into an eco-­
nomy. High tax rates, on the other
hand, seriously distort
allocative decisions and erode
incentives to work, save, and
invest. Goode observes that top rates
often are unrealistically
high, occasionally exceeding
90 percent. Excessive rates, in
his words, "are likely to discourage
effort and investment and to
provoke avoidance and evasion."-
Goode demurs on the issue of
just how high the top rate
should be, insisting that no
general
answer can be given. One reason is that, for him,
equity

89
requires a progressive system, in which those earning higher

incomes pay higher proportions of their income in taxes, even

though "a pronounced degree of progressivity. . . in practice has

seldom been achieved." 7

Individual income taxes contribute varying shares of total

revenue in developing countries. Excluding the oil-exporting

countries, in Africa, 23 countries receive less than 10 percent

of total revenue from individual income taxes, 11 from 10-20

percent, and only Liberia, South Africn, and Zimbabwe collect

over 20 percent. In Asia, the individual income tax is a more

significant source of revenue: 4 countries collect less than 10

percent, 5 collect from 10-20 percent, and 2 more than 20

percent. Outside Israel, virtually no Middle-Eastern country

'-vnds on the individual income tax. Among developing countries

h;- Western Hemisphere, the highest take is 17.5 percent. For

' reported data, 10 countries colloct less than 10 percent,

and 10 collect from 10 to 17.5 percent. These relatively small

proportions are often compared with the indUstrial countries in

which individual income taxes range from as low as 8.4 to as high

as 57.2 percent, with the average running well over 20 percent.

These figures give many analysts of less developed countries

concern that attempts to link the structure of marginal tax rates

and the income tax base with the determinants of economic

growth is misdirected. But the economic damage caused by a tax

that raises little revenue can be substantial. For example, a

100 percent tax on any import may raise little to no revenue, but

90
=ompletely retard an industry dependent on imported inputs.

Similarly, high export taxes on agricultural goods collect

little revenue, yet discourage commercial production in favor of

subsistence agriculture. Likewise, a system of high marginal tax

rates may raise little revenue, yot prevent the emergence of

equity markets, disccurage prospective entrepreneurs, drive

people into the underground economy, foster tax shelters, and so

on. Thus any system of high rates of tax has the potential to

wreak economic havoc far out of proportion to any revenue it

generates.

A neutral, efficient, equitable tax system is usually a

proxy for an overall set of sound economic policies. Governments

that pursue sensible regulatory, monetary, trade, and budgetary

policies are unlikely to maintain tax systems with excessively

high rates.

Table 6 clusters countries by the level of top marginal rate

and the threshold at which the top rate takes hold. These

clusters reinforce the notion that sound, growth-oriented

policies cohere in packages. The low top rate/high threshold

countries have enjoyed consistently higher average rates of

growth than countries with high rates and/or low thresholds.

To supplement this cross-sectional comparison, we have

assembled time series data on changing rates and thresholds of

taxation.

The conclusion of this report contains plots of the annual

changes in top marginal tax rates and thresholds for nineteen

91
 Depending on the availability of data, the
developing countries.
1956­
periods under investigation for some countries encomoass

85; others include only the years 1963-85, 1974-85, or 1979-85.

The ready availability of tax information published by Great

Britain's Inland Revenue Department on British commonwealth

those
countries permits 30-year trend lines to be drawn for

countries. The combined commercial reports of Price Water­

house and Coopers & Lybrand omits tax information for the

years 1975, 1977, 1978, 1980, and 1983. Missing data appear in

the trend lines as dots connecting reported observations.

The nineteen plots illustrate three radically different

individual
experiences with developing country policy towards the

income tax. Four countries (Hong Kong, India since 19Y4,

.!innesia, and Sirgapore) show a commitment to supply-side

u i. One (Phillipines) briefly attempted marginal rate

dut-tions with little success. The remaining fourteen countries

and nine in
(one in Europe, four in the Western Hemisphere
the rich,"
Africa) show excessive concern with equity, "soaking
eroding
and a general disregard for the adverse effects of

incentives due to high rates of tax.

Pro-Growth Individual Income Taxes

The British Crown Colony of Hong Kong, as previously

described, is the quintessential neutral, low-tax, supply-side

revenue system. Throughout its entire postwar development,

92
public officials have emphasized the need for low rates of tax,

stability in the rates, and preventing inflation from pushing

taxpayers into higher brackets by adjusting, when necessary, tie

thresholds on which tax rates are applied. Hong Kong's low-tax

system goes hand-in-hand with budgetary balance, free trade,

sound money, and reasonable regulatory requirements.

Along with Hong Kong, Singapore has enjoyed high rates of

growth for several decades. Shortly after independence, Singa­

pore's leaders stretched the top rate from 30 to 55 percent by

1961 on taxable income exceeding US$30,000. Since per capita

income in Singapore was below US$1,000, only a handful of

the population paid high rates. But Singapore's leaders have

remained conscious of the disincentve effects that would confront

its citizens as growth pushed the middle class into high tax

brackets; accordingly, they raised the threshold for the top

rate from US$30,000 in 1970 beyond US$100,000 by 1977. Moreover,

in 1979 the government announced a series of rate reductions

that slashed the top rate to 40 percent in 1985. With per capita

income of $6,800 in 1985, nost Singaporeans face an effective tax

rate (disregarding personal allowances) 10 percent. But even

millionaries get to keep 60 cents of each additional dollar.

The nineteen graphs display changing thresholds in nominal

U.S. dollars that do not take inflation into account. Between

1967 and 1984, the domestic price level in the United States

tripled. If thresholds were expressed in constant dollars,

$10,000 income in 1967 would represent the same purchasing power

93
 as $30,000 in 1984. A falling threshold trend line expressed
in
nominal or current dollars thus grossly understates
the true
extent uf bracket creep. It would be necessary to triple
thresholds between 1967 and 1984
to reflect changes in the price
level. A modest upward trend line may not
fully offset the
effect of inflation on purchasing
power.
Examine the plots for India. The first phase of tax policy
consists of increases in the top
marginal rate from 73.5 percent
to the incredible level of 97.75
percent in 1973. Up through
1969, the government partly offset
the effects of higher rates
by raising the threshold from approximately
$14,000 to $33,000.
?ut as tax rates peaked, the threshold
was slashed to a mere
'17,500, thus exposing greater numbers
of Indians to the top
Pi'-Te final phase of income tax policy
has consisted of
v0 -ining a relatively constant threshold in
nominal terms
.; -ikllingin real terms), while systematically reducing the
p marginal rate of tax. A declining threshold has offset
some
beneficial effects of lowering the
top rate. Compared with its
initial post-indEpendence high tax policies,
India has embarked
on a supply-side path in recent years.

Since 1979, Indonesia has undertaken

a concerted effort to
inject incentives into the economy,
minimize tax avoidance and
evasion, and reduce dependence on
oil receipts in the face of
declining oil prices. Indonesia has reduced its top marginal
rate from 50 to 35 percent, and raised
the threshold from
US$15,000 to US$50,000. Receipts from the income tax have
risen

94
 in 1965, both in absolute terms
and as a share of total revenue.
Cutting tax rates and increasing
thresholds have had a Positive
effect on revenue and growth
was a healthy 4.5 percent in
1984.

The Importance of Threshold

The Phillipines illustrates

wild swings in fiscal policy.
In the early 1970s, a top marginal
rate of 55 percent applied
to
taxable incomes exceeding US$90,000.
By 1979, the government
raised the top rate to a prohibitive
70 percent, at the same time
the threshold fell to $60,000.
Recognizing that these trends
lines were counterproductive
of efficiency and revenue,
the
fiscal authorities cut the
top rate to 35 percent in 1982.
Any efficiency gains that might
have ensued were suppressed
by
the international recession
that affected the Phillipines
and its
trading partners. Additionally,
a portion of the supply-side
gains was dissipated by the
sharp fall in the threshold.
By
1985, the worst of both trends
had materialized: the top
marginal rate stood at 60 percent
and the threshold fell tcj
$25,000. Adjusting for inflation, $25,000
in 1985 is worth
about $10,000 in 1974. The Phillipines in 1985 possessed
a high­
rate, low-threshold tax system.

Anti-Growth Tax Systems

The socialist revolution in

Portugal was accompanied by
a

95
 dramatic transformation of the individual income tax system. T-.e
new rulers raised the top marginal tax rate of 45 percent in 1969
to 90 percent by 1976; it was slightly rolled back to the

mid-70s by 1984. Not only were marginal rates sharply increased,

the threshold was reduced from over $100,000 in 1969 to a $20,000

in 1979. The middle clases faced confiscatory rates of personal

taxation on modest levels of taxabale income. These changes

seriously eroded incentives to work and invest.

Four countries in the Western Hemisphere illustrate the same

pattern: Brazil, Chile, Jamaica, and St. Vincent. Brazil

evinces a rise of 10 percentage points in the top marginal rate

from 50 to 60 percent, at the same time that its threshold

declined by nearly two-thirds from $76,000 to $28,000. In Chile,

,-tatutory top rate was reduced from 70 to 55 percent, but

~~ir inflation eroded the applicable threshold from a high

t:.ceading T100,000 in 1975 to a meager $3,000 by 1984. This

me;'ant that the entire economically active population faced the

top marginal tax rate--a flat tax of 55 percent--on almost all

taxable income.

Through virtually its entire post-independence era, Jamai­

cans have faced a top, stiff tax rate of 75 percent, ranging as

high as 80 to as low as 57.5 percent since 1981. As the lower

rates have come into effect during the 1980s, the threshold nas

collapsed from a comfortable $20,000, thus excluding the over­

whelming majority of the population, to a low, low $2,800. Small

wonder that Jamaica exports talented people. Any skilled or

96
 rate from about 50 percent in the early 1960s to 80 percent.

Kenya, Malawi, and Pakistan have enjoyed higher growth than

the preceding five nations. Although Kenya sustains a 65 percent

top rate, the thr-eshold, until 1984, remained well above $20,000,

thus e:iempting all but the upper-middle classes. Between 1970

and 1980, Malawi enjoyed a relatively low-tax regime by African

standards, hovering in the 40-percent range. Malawi's slower

progress since 1980 may be partly attributable to its rising top

rate and declining threshold, which has now fallen beneath

$10,000. Pakistan illustrates the hazards of failing to adjust

thresholds to offset inflation and changes in exchange rates.

The effective marginal tax rate faced by successful Pakistanis

ham sharply increased since 1979, as the threshold has eroded

i_ )y $40,000 to under $10,000. Finally, Tanzania is a

et~ous case, with a top marginal rate of 95 percent coupled

rapidly shrinking threshold.

The majority of poorly-performing developing countries

reveal the same pattern of high and often rising tax rates

applied to lower and lower thresholds of income. It is no

accident that individual income taxes contribute small propor­

tions of revenue in many of these countries. High tax rates have

frustrated the efficient use of labor and capital and discouraged
entrepreneurship, thus holding down growth. The Indonesians and

Indians, have recently discovered, as Hong Kong's leaders have

always maintained, that reducing rates and increasing thresholds

both stimulates growth and increases revenue.

98
 Notes to Chapter IV

1. K:uwait, Oman, and the United Arab Emirates have been elimi­

nated from the data file since all receipts are derived from oil

exports and their various, high-score development indicators are

solely due to the interplay of high oil receipts and small

populations. These three cases constituted serious outlyers and

they were removed to eliminate unnecessary distortion in the

analysis.

2. The precursor to this series is Income Taxes in the British

Dominions (London: Inland Revenue Department, 1923) with revised

editions in 1928 and 1938. Theses volumes were originally

published to provide concise information on taxatio i in the

1

colonies and dominions to cope with problems of double taxation

confronting British expatriates.

An essay by Sohrab Abizadeh and J.B. Wyckoff, "Tax System

Components and Economic Development: An International Perspec­

tive," Bulletin, International Bureau of Fiscal Documentation,

1982, pp. 483-91, reports on an international study of direct and

indirect tax revenues in different countries at different stages

of economic development. In the majority of case studies, of

which 22 were LDCs and 19 were advanced natioons, the tax system

changes towards more intensive use of direct taxes as the

nation's economy develops. The findings did not hold up for the

period 1950-59, but fit the period 1960-72. However, the general

conclusion doesn't apply to the LDCs very well. The authors

conclude that "There is no hard evidence, based on the result

99
 obtained, that the group of [22] underdeveloped countries has

increased its relative reliance in direct taxes as their economy

developed." Indeed, since the direct tax ratio decreased for

this group of countries, it was concluded that the imposition and

collection of direct taxes are practically impossible and

encounter numerous administrative as well as political and social

obstacles. The authors also note that direct taxes have been

losing their relative importance in the budgets of the govern­

ments in developed countries. We should note that our results

encompass growth between 1960-e2 and apply to 92 LDCs.

Somewhat troubling is the authors' premise that a "better

tax system" is one that results in higher taxes as a proportion

of GNP as a result of development, regardless of its source as

direct or indirect taxation. The notion that "better" transfers

a growing proportion of development into public hands for

" rather than leaving funds in private hands for invest­

jor consumption, must cast serious doubt on this generally

:...i.:ed view of better taxation, especially since the evidence

.. A developing nations' public sectors are highly inefficient is

r,ot widely acknowledged.

4. Richard Goode, Government Finance in Developing Countries

(Washington, D.C.: The Brookings Institution, 1984), p. 106.

5. Ibid.

6. Ibid.

7. Ibid., p. 79.

100
 LEGEND OF VARIABLES USED IN THE ANALYSES

Variable Identification

TXPCGNP Taxes as percent of gross national product

DIRECTTX Direct taxes as percent of total revenue
(Income tax, social security tax, payroll
tax,
property tax)
MR84 Top Marginal Tax Rate, 1984
TB84 Top Tax Bracket, 1984
INDIRTAX Indirect taxes as percent of total revenue
(Domestic excises, international trade
taxes,
other taxes)
PERCPGNP GNP per capita in U.S.$
GROWTH Average annual economic growth rate, %,
POLRTIDX 1960-2
Political rights index (1-most free; 7-not
CIVRTIDX .rr-,)
Civil rights index (1-most free; 7-not
rc-
COPOLSYS Political System
EXPGR01 Average annual growth of exports, %,
EXPGR02 9.i
Average annual growth of exports, %,
IMPGRO1 j9,
Average annual growth of imports, %.,
JG9A2 :
IMPGRO2 Average annual growth of imports, %,
'9-T-
i
PUBCONG1 Average annual growth of public consumptir
, .,
1960--70
PUBCONG2 Average annual growth of public consumption,
%.
1970-82
PRICONGI Average annual growth of private consumption,
%,
1960-70
FRICONG2 Average annual growth of private consumption,
%,
1970-82
INVGROI Average annual gross domestic investment
growth,
%, 1960-70
INVGRO2 Average annual gross domestic investment
growth,
%, 1970-82
BUDGSD Budget Surpl(s/Defici':, % GNP
EXTPUBDB External public debt as percent of GNP
INFLRT Average annual rate of inflation, %, 1970-82
AGGRRT Average annual growth rate of agriculture,
%,
1970-82
INDGRRT Average annual growth rate of industry,
%, 1970-82

101
 SIGNIFICANT BIVARIATE RELATIONSHIPS

Variable with Variabhe Correlation Significance

TXPCGNP AGGRRT -. 49 .006
GOVEXF' .40e .009
DIRECTTX PRICONG2 .229 .028
GOVEXP .298 .009
PERCPGNP .312 .001
MR84 PERCPGNP -. 444 .000
BUDGSD -. 272 .039
TB84 PERCPGNP .260 .026
INDIRTAX IMPGRO2 -. 34 .002
PRICONG2 -. 329 .003
INVGRO2 -. 206 .042
INDGRRT -. 226 .03
GOVEXP -. 396 .001
PERCPGNP -. 502 .000
PERCPGNP PRICONG2 .30 .006
EXTPUBDB -. 22 .03
INFLRT .186 .038
DIRECTTX .312 .001
INDIRTAX -. 502 .000
TB84 .26 .026
MR84 -. 444 .000
GROWTH EXPGR02 .34 .003
IMPGRO1 .23 .028
IMPGRO2 .496 .000
PUBCONG2 .587 .000
PRICONG2 .68 .000
INVGRO1 .456 .000
INVGRO2 .552 .000
EXTPUBDB -. 27 .01
AGGRRT .33 .002
INDGRRT .68 .000
DIRECTTX .261 .006
INDIRTAX -. 425 .000
EXPGR02 GROWTH .34 .003
INDGRRT .57 .000
PRICONG2 .27 .008
PUBCONG2 .30 .03
INVGRO2 .35 .002
IMPGRO2 INDIRTAX -. 34 .002
GROWTH .496 .000
PUBCONG2 GROWTH .587 .000

102
Variable with Variable Correlation Significance

PRICONG2 DIRECTTX .229 .02S

INDIRTAX -.329 .003
GROWTH .68 .000
PERCPGNP .30 .006

INVGRO2 INDIRTAX -.206 .042

GROWTH .552 .000

EXTPUBDB GROWTH -.27 .01

PERCPGNP -.22 .03

INFLRT PERCPGNP .1B6 .038

AGGRRT TXPCGNP -.49 .038

GROWTH .33 .002

INDGRRT iNDIRTAX -.226 .03

GROWTH .68 .000

GOVEXF TXPCGNP .406 .009

DIRECTTX .298 .009
INDIRTAX -.39B .001

BUDGSD MR84 -.272 .039

103
 FIGURE 1 (N=49)

DMW: TVCM TAXES AS 2 GH PCROSS: GROVTH AVG, A IJAL GROVTH RATE Z

-2.3 -1.2 -0.1 1.0 2.1 3,1 4.2 5,3 6,4 7.5
i iI'-- , -- - -- ---- 1-t- f --­ -------- 4--46
36.0 + + 36,0
I I
I I
I I
I I
33.3 + f 33.3
I I
I
I I
I I
30,6 f 30.6
I I
I I
I I
I I
27.9 + + 27.9
I *$3
I $ I
I 3 I
I I

8 11 2,
I I
I 3 1
*'f 22.5
33 I
T 3 I
3 I
* 3 + 198
$ I
* I
3 I

9.0 + 171
; I
I 3 33 1
. I
I * I
t4.4 +Il + 3 + 1 14.4
1.
I I
1 * 3 I
1 * $ I
I 3 3 1
11.7 - + 11.7
I I
I 3l I
I I
9.0+ 3 3 + 9,0
.;.. , . . ,. .. ; , , : : : : I I, . .I I I ',
-2.9 -1.7 -0.6 .4 1,5 2.6 3.7 4.8 5.8 6.? 8.0

104
 FIGURE 2
143W: ('=92)
G.OUTH 'AVG. AWMUAL GORTH RATE
3. ON 11.664 1, ACOS,; rIlECTTX 'SUN OF
19.440 27,216 INCTAX SST PAYROLLT PROP
..... - +-'+---4---- 34..'-V 42.768
f--- ...---- 504 832
-------- S$4
-82
--- 6696
-9
--- -------- 7,2
I
_+_
I 1
II I + 8.0
1I I
I
I I
6.9+
1 1 1
9~ I
I 1 +
Il1 1 6.9
.
5.8 1
1+
1 9 9.I
I 9
I
1 I
1 1 S.
4.8+ 19 I
1 9 1 I
9 91 1
4.8 + + 5.8
9 9 91
199
I
9 1 9 1
9 I 91
9
1 I
... . 9+ I91 4.
9+ 19
9 1
119
S9 19 3
2.4 9 1
1I 9 1 9 9
9 9 9 I
2 1 9 99
9 991 1 4 2.6
S91 9 9 9 9 191
I 9 1 9
9 1 9 I
9 1
1 2.6
9 9 1 1
1 9 9
1.5 + 1
9 I
99
I
9 9
99.91 9 991 9 9
4
.4+
1
9919 9
119 19 1+
I .
1I I
1 9 9
9 9 1 1
-. 6 + ,9
1 I
I
1 9 I
I I
1
1 1 -. 6
I 111
-1.7 I 9
I+ "I 9
II
I -2.8
II
III10
-2.8+ I -4.9
9 I I
!
0.0 7.776 -2
15.552 23.328 31,104 38.980 4665 54.432 62.20B 69,984 77.7 0

105
 FIGURE 3 (N=65)

W01W INI1
PR2 AM NAfLfRTh OF IIPURTS Ir ACROSS: INDIRTAX SUN OF IMST ITRADET OTlOT
4.917 14,750 24.583 34.416 44,249 54,082 63,915 73.74? 83.580 93.413
17,2 + ++ 17,2
1 I
I I
I
I 1
I
14.2 + 14.2
8 1
II
t I
I I
!1,3 + $ 11,3
I I
I I
I 8 $ I
8.3 + 8 + 8,3
I II
2 I
I * 8 8 1
I I
,~88+ 5$.4

88 I
*8 $ I

I I

88 8888 I

I I
I

I I
1 1
-6,5 I+ + 8 I -3.5
I 8i
I 8 I
I SI
I !
-6.5 * * -6.5
I 8
I I
I I

-12.4 * 8 * -12.4
 FIGURE 4 (N=92)

DM#: GROTH 'AVG. MWA. GOTH RATE A,OS: INDIRTAX 'SWtOF DWIEST ITAITTHERT'
5 15 25 35 45 55
..---_-_------------ - ------ 4 -65 --+ -75- - + _. 95 95
_ _+ __+ _
17 +
+ 17
I I
I I
I
I
II
1 1
15
I€
IS
135 4 I
I 1 3
I
I
13 + I
I I
4 i
I I
I
I
114i
+I
I 4I
I
I
I
I
I
I
94 9
II
+I 9

9 9 I
74 7
I 9 99 +
I I
91 9 9
I 9 99
I
549 I 9 999 9 9 94I 5
91 9
1 9 9 99 9 9 1
I 9 9 9 1
34+1 99 9999 9 9
9 9 + 3
II 99 9 9 9 99 9
9 9 99 I
I 9 9 9 9 9
I 99 9 9 9999 1
I
14 9 99
I 99 9 99 + 1
I
1 99
I 99 9 9
1 I
9 9 I
-14 9 9 4 -1
I 9 z
II
I
I
I I
I
-34 9 -3
0 10 20 30 40 50 60 70 90 90 100

107
 'TABLE i' ~ ~ "

C--
R '0RO TA RU L A TI1,0N
ST, OF
0'
CODEG 'GROUPED GROM:H RATE BY POLRTIDXM 'POLITICAL RIGHTS INDE
---
- - - - - - -t

~ KPOLRTIDX
I ROW :+KT
: 1, u iSI 71 iiii iiiii l
": CLPTil''*~ 21 31< 41 5OTA6.
o. .? ...... ?++S+ ++++i
++ +++
++++
++++ +: ++++ -++

11 I 1J' 2 I 1 ' 3 1 2 1 I 12
1
2.040 1 1 8.3 V416.7, 1, 83 1I25,0 1 16.7 1 25.0 1 12,9
1 1 5.61 1'2001 12,5 1 17.6" IM1.3 8 1B~9~
2 1 1 4I i 11 1,I 3 1 3'Ii 13
to I1-1 00 1 1 30.8 1 :7d1 7071 7.7 1 23,1 1 23*1 1 14.0
1'.>22,2 110.0 1 1205 1 56'9'. 120.0", 181.0 1 . ..

3'I> ' 4 1 I I1 3
31 ,2I 5'1 16
1 6,.31' 25.0, I 1 6.3 1 184B 1 12.5 1 31.3 1 17.02
1 11.11 1 '22.2 1 1 12.5 1 1746 1 13*3k 1 3103 1

I 5,9 111.8 I 11,8 1 11,8 1 11#8 1 29.4 1I,17 6 1 18.3

I I lbI I111.1 1.20.0 1 25.0 1 11.8 I 13,3 1 '18,98 I

31
3 4 1,2 1 '21 2 1 1I'1 11 5
-. T 001 26.7 1 13.13 IM 13,
U 1,13.3 1 6.7 1 6.7 1 1-+++ + +• , + - V..
V
'V *++AVVV 'S V.'.UV?
'V '\.VV< V',) *VV+'
rf ''*192 Uj-'4
V,<.'V 4Ul.'
.'4' ,.V++--,VV'
V 1.127,3
, 1 127.3 V
1i18.2
J' I £+ +-++, ++ ++:+++++
I i1.8 +.,.
+++:++++++VV
++++ +++++ V+>
, j'V VVV++
<V++
:+
'V'+
V+
' , '6 I 30'00 1, 1 174 1 13.3 1 1 V V
-'Vi:++;+ + - "'.'f'V''V'"'
~-,V.,V * KV~"-.VhV.
18f+ 1 4 '+'
VV~ .V +++'+ +
, wuuu
+K'+'<9 ''.V'9 ' j9,3
' VV
4VlJ 2jjj1s'
V+;+++++
TOTN
+:+"9;5 p1'16
. "+93 V:
72 -V+:+, :V +' ++
V+
'!+++ +++++++
':,++:+:i+' V.- V'4
++++:
VA V
115.'74,1 ,1 1
I 1
.0gV "VIIV 1
SI 5 ~ 5-.1,1 .
'. 1 L IU 1'42.2 ~VVVV~
I 56I' V...........
1Kj 12,5 76 \ V1
VI" 1~ V. ,I,
V VVVVV. VVV+~
+VVVVV'VV++++:++++
+ . . . . . . +++!
++
TOTA
9.7 19.V4
4 '" V' 8; aV
~VV
IS0'316'
1VV
­ 172 ,., K
4"V
 TABLE 2

- - '-jP
- - - -- BY CIVRTIDX 'CIVIL RIGHTS MM'

CIWTIDX
COTI
RON PCT I
COL PCT I
ROM
1 11 21 31 41 51 61 71 TOTAL

i1 I 21 I 21
-2,-.0 1 21 31 31 12
I 16.7 1 I 16.7 I 16,7 1 25.0 1 25.0 1 12.9
1 1 12.5 1 I 20.0 1 8.0 I 1A.7 1 30.0 I
21 I 11 3 1 1
0.1-1,0 61 21 1 13
1 I 7.7 1 23.1 1 1 46.2 1 15,4 1 7,7 I 14,0
I 1 6,3 1 250 1 1 24,0 I1l& 1 10,0I
+--- i I
3 11 21 41 11 21
1.1-2.0 1 1 12.5 1 25.0 I 6.3 1 12.5 I 31,351 2 1 16
1 12.5 1 17.2
I 112.5 I 33.3 1 10.01 ,O
0 I 27, 1 20.0 1
41 11 21 1 31 41 5 21 17
2.1-3.0 1 5.9 I 11.9 1 1 17.6 1 23.5 1 29,4 1 11,9 1 19.3
1 50.0 I 12.5 1 1 30.0 1 16.0 1 27.8 I 20.0 1
51 11 41 3 1 21
3.1-4,0 I 6.7 1 26.7 1 20.0 1 13.3 1 26,741 1 1 1 15
1 I 6.7 I 16.1
1 50,0 I25*0 1 25.0 1 20.0 1 16I.0 1 1 10.0 I
61 1 31 II 11
4,1-5.0 31 31. I 1
I 1 27.3 1 9.1 1 9.1 1 27.3 1 27.3
I I 1 18
1 18.I8.3 I 10.0 1I12 I 16.7I
I
71 I 2 1 1 I
5.1-6.0 I I 11 3
1 1 6.7 1 I I I I 33.3 1 3.2
1 1 12,5 1 1 1
+--+--- I
,--- , I Ii------',
I 10,0 1
t
1 I I 1 11 I 3 1
6.1-7,0 1 1 1 4
1 1 25,0 1 1 75.0 1 1 1 4.3
1 1 1 8.3 1 1 12.0 I I I
9 1 I 1 1 1 1 1 1 1 1 2
7,0+ 1 1 I I 50.0 1 50,0 1 1 1 2,2
I I 1 1 10.0 1 4,0 1 I I
COUN 2 16 12 10 25
TOTAL 2.2 19 10 93
17.2 12.9 108 26.9 19,4 10,8 100.0

109
 TABLE 3

.......... C R O S S T AD U L A T I ON OF . . . . . . . . .
CommCS 'GROUP PWpI' BY POLRTIDX 'POLITICk RIGHTS IkIEX'
------------------------------------------------------

POLRTIOX
COU I
ROW KeT I RO
COL TI TOTAL
I 11 21 31 41 51 61 71
cD PCG: I I" I I i -'I4'- ,­
II I I I I 1 1 21 41 7
0200 I I 1 14.31 I 128.6 157,1 1 7.4
1 1 1 1000 1 1 1 13.3 1 25.0 1
j , . i Ji ... ;i
21 1 1I 21 21 I 5 1 I 1
$201-400 1 I 5.6 I ll1 I 11.1 1 I 27, I 44,4 I 19.1
I 1 5.6 1 20.0 1 25.0I 133.3 1 50.0 1
i i i +--- -----­
-4
3! 1 41 2 I1 I 6 2 1I1 16
$401-700 I 1 25.0 1 12.5 I 6.3 1 37.5 I !2.5 I 6.3 I '7,0
I 1 22.2 1 200 1 12.5 1 333 1 13.3 I 6.3I
i I 'I '; I -+- :, -- :­
41 11 21 1 31 41 21 1 1 14
V01-100 1 7.1 1 14.3 I 7.1 I 21.4 I 2.6 I 14.3 I 7.1 I 14.9
I 11,i I 1h1 I 10.0 1 37.5 I 22.2 I 13.3 1 6.3 1

51 21 6 1 1 I 21 1 11 12
1 16.7 1 50.0 I 9.3 I 1 16.7 I I 8.3 1 12.8
1 22.2 1 33.3 1 10 ,1 1 11.1 1 6,3 1
+ I I Ii I
61 1I 1 31
3! 1 1 1 6
I 1 16.7 116,7 1 1 50.0 1 16,71 1 6.4
I 1 5.6 1 10.0 I 16.7 1 6.7 1 I
7I I ;]I 2I iI 2 I I I 1
7 1 "441 3 1 21 11 21 31 1 115
12001-4000 1 20.( I 20,0 I 13.3 I 6.7 I 13.3 I 20.0 I 6,7 I 16.0
1 33,3 I 16.7 1 20.0 1 12.5 1 11.1 1 20.0 1 6.3 1

8 1 21 1 1 I 1 1 1 1 I 4
6400I-6w 1 50.0 1 25.01 1 25,01 I I 4.
I 22.2 I 5,6 I 1 12.5 1 I I I

9 I 1 I I I I I I 1 2
0600O+ 1 50.0 I I I I 50.0 I I I 2.1
I 11,i I I I I 5.6 I I I
cOLIm 9 18 10 S I 15 16 94
TOTAl. 9,6 19.1 10,6 8.5 19.1 16.0 1,.0 100.0

110
 TABLE 4

. .. ..... . .... . ..-- C R O S S T AP U L T IO

coi~ecs 'o Petcg' OF .... .... .. ..
BY CIVRTIDX 'CIVIL RIGHTS NW'

CIVRTIDX
COUNT I
ROM PCT I
COLPCT I RU
COd ---- 1 4- 11 ... --
21 ~ I31
~ TOTAL
I41 - 51 61
I I71
W00. I I
1 1 11 14,3 1 14,3
1 10.0
1 I3-8 I1 14,3
5- 11 57,1
40.0 11 7.4
2 1 1 1 1 2 1 4 1 81 3 1 18
$201-400 1 1 I 56 1 11-1 I 22.2 1 44.4 1
1 16.7 h 19.1
1 1803 1 20.0 1 15.4 I 44.4 1
30.0 1
3
2 1 6 1 4 1 1 16
*401-700 1 I 6.3 1 18,0 1 12,5 1 37, 1
5 2,0 I 1 17.0
I, 1
-; 6.3
,i 11 25.0 1 20.0 1
-4­23.1 1 22.2 I I
+..j
- -
41 I 31 21 21
$701-1000 1 51 1 1 114
I 21.4 I 14.3 1 14.3 1 35.7 1
I 1 18.0 1 7.1
16.7 1 20.0 1 19.2 1 5,6 II 7.1 1 14.9
1010 1
51 21 21 41
1001-1500 1 21 21 1 12
1 16,7 1 16,7 I 33,3 1 1 16.7 1 16.7 1
1100.0 1 12.8
12.5 1 33.3 1 1 7.7 1 11.11 1
I I I 1
1I 41
$1501-2000 1 1 16,7 I 1 II 6
I 1 66.7 I I 16.7 1
1 1 6.3 1 6.4
1 1 15.4 I I 10,0 I
7 1 I 51 21 31
$2001-4000 1 1 33.3 I 13.3 1 20.0 1I 13.32 1I 21 1 1 15
1 6,7 1 16.0
I 1 31.3 u167 1 3,0 1 7,7 1 111 1 10,0 1
81 1 31 1
40I-6000 1 1 11 1 1 4
I 75.0 1 1 1 25.0 1 I 1 4.3
I 1 18.8 1I 3.8 1 1

p60+1 1 50.0 1 11 1 2
1 1 50.0 1 1 1 2.1
1 16.3 1 1 1 3.8 1 1 1
COIWBI 16 12 10
TOTAL 26 1S 10 94
2.1 17.0 12.0 10.6 27.7 19.1 10.6 100.0
 TABLE 5

Dependent Variable: GROWTH

Indep. Var. B SE B T SaJ

1. INVGRO2 .1283 .02e6 4.491 .000
2. INVGRO1 .1387 .0346 4.013 .000
3. DIRECTTX .0377 .0117 3.231 .002

Constant -0.7569

R Square .4998

F= 17.6541

Signif. F= .0000

nor-bin-Watson: 1.6147

56

V.,riables Not Included

. EXPGR02

2. IMPGRO1

3. IMPGR02

4. EXTPUBDB

5. INDIRTAX
 TABLE 6
CURRENT MARGINAL TAX RATES
AND AVERAGE ANNUAL ECONOMIC
GROWTH

IN LDCs, 1960-1982

Low Tax Rates - All Thesholds

(MTR: 0 - 24%)
Country Growth Rate Mean
Hong Kong 7.0% 7.0
Medium Tax Rates - Low and Medium Theshold,
(MTR: 25- 49%;
T: X 0 - 50,000)
Country Growth Rate Mean

Argentina 1.6
Bolivia 1.7
Ivory Coast 2.1 2.1
Paraguay 3.7
Solomon Islands 1.3

Medium Tax Rates - High Thesholds (MTR: 25-49%; T: $50,001+)

Country Growth Rate Mean
Indonesia 4.2
Singapore 7.4
Venezuela 4.5
1.9

High Tax Rates - Medium Thesholds (MTR: 50%+; T: $20,001-50,000)

Country Growth Rate Mean
Belize 3.4
Botswana 6.8
Brazil 4.8
Cyprus 5.9
Dominica -0.8
Malaysia 4.3
Morocco 2.6 3.1
Nigeria 3.3
Phillipines 2.8
Senegal 0.0
South Africa 2.1
Trinidad & Tobago 3.1
Zimbabwe 1.5

113
 High Tax Rates - High Thresholds (MTR: 50%+; T: $50,001+)
Country Growth Rate Mean

Dominican Republic 3.2

Ecuador 4.8
Egypt 3.6
Korea 6.6
Liberia 0.9
Mexico 3.7 3.9
Nicaragua 0.2
Panama 3.4
Taiwan 7.0
Thailand 4.5
Tunisia 4.7

High Tax Rates - Low Thesholds (MTR: 50%+; Ti $ 0 - 20,000)

Country Growth Rate Mean

Bangladesh 0.3
Barbados 4.5
Chile 0.6
Costa Rica 2.8
Fiji 3.2
Rhana -1.3
(ndii a 1.3
.Iav., i r-a 0.7
2.8 1.9
8.0
'akstan 2.8
St. Lttcia 3.4
St. Vincent 0.6
Sudan -0.4
Swaziland 4.2
Tanzania 1.9
Turkey 3.4
Uganda -1.1
Zaire -0.3
Zambia -0.1
 TABLE 7

Dependent Variable: EXPGR02

Indep. Var. B SE B T Sig T

1. INDGRRT .7959 .1491 5.337 .000

Constant -1.3377

R Square .3371
F= 28.4789

Signif. F= .0000

Durbin-Watson: 2.1270

N= 57

Variables Not Included

1. INVGR02

2. IMPGRO1

3. IMPGRO2

115
 TABLE 8

Dapendent Variable: IMPGRO2

Indep. Var. B SE B T Sig T

1. INVGRO2 .4586 .0930 4.931 .000
2. EXPGR02 .2841 .0912 3.114 .003

Constant -0.2426

R Square .5018

F= 27.6929
Signif. F= .0000

Durbin-Watson: 1.7322

N= 57

"Ariables Not Included

- INDIRTAX

?. AGGRRT

3. INDGRRT

116
 TABLE 9

Dependent Variable: GOVEXP

Indep. Var. B SE B Ti
1. TXPCGNP .B479 .3408 2.466 .01B4

Constant 10.3025
R Square .1664

F= 6.1894
Signif. F= .0164

Durbin-Watson: 1.8365

N= 32

Variables Not Included

1. DIRECTTX

2. INDIRTAX

117
 TABLE 10

Dependent Variable: EXTPUBDB

Indep. Var. B SE B T Sig T

i. GROWTH -3.5614 1.8190 -1.958 .0580

Constant 45.0326

R Square .0962

F= 3.8333

Signif. F= .0580

Durbin-Watson: 1.6819

N= 37

'.- bles Not Included

TXPCGNP
 TABLE 11

Dependent Variable: PRICONG2

Indep. Var. B SE B T
1. GROWTH .9654 .1292 7.470 .000

Constant 1.9150
R Square .4544

F= 55.8046
Signif. F= .0000

Durbin-Watson: 1.8937

N= 68

Variables Not Included

1. DIRECTTX

2. INDIRTAX

3. PERCPGNP

119
 TABLE 12

---------------- --- CROISTAJULATION OF ............

CNWIl 'POLITICAL M1TE3' BY POLRTIDX 'POLITICAL RIGHTS INI'

POLRTIAX
COUN4T I
ROM PCT IROW
COL PCT I TOTAL
1 11 21 31 41 51 61 71
CDPO SYS i - -i i i- I ,i
II 91 1I 1 61 21 31 1 138
ILTIPARTY 1 23.7 1 474 1 15,8 1 5.3 1 7.9 1 1 138.0
1 1000 I11000 1 600 1 25.0 1 14.3 I 1 1

21 1 I 31 5SI I 1 1 11 19
DONIJWPARTY I I I 16,7 I 27,6 I 44,4 I 5.6 I 5,6 I 18,0
I 13 0 62,5 I 38,1 63 1 5,6 1

31 I I I II 41 12 1 9 1 25
IrMY I I I 1 4.0 1 16.0 1 48.0 1 32,0 1 25,0
I I I I 12.5 1 19.0 I 75.0 I 44.4 I

41 I I I I 21 3: 91 14
*,.'LThY NILITA I I I I I 14.3 I 21.4 1 64.3 I 14,0
I I I I I 9.5 1 18,9 I 50.0 I
i.. i ' i .... i i i
5I I 1 I I I 41 I I 5
M-PARTYMW-*II I I 20.0 I I 90.0 I I 1 5.0
I I 1 10.0 I I 19.0 I 1 I

CmL 9 19 10 8 21 16 19 100
TOTAL 9.0 16,0 10.0 9.0 21.0 16.0 18.0 100.0
 TABDLE 1­

....
... ... ... ... CROSG TAB ULAT1 ON OF . . . .
CDPOLSYS 'POLITICAL SYSTEM' BY CIVRTIDX 'CIVIL RIGHTS INEX'

CIURTIDX
cow I
RONPCT
CO TII ROU
TOTAL
I 1I 21 31 41 51 61 71
II 2 16 1 10 1 41 5 1 II
IULTIPARTY 1 5.3 1 42.1 1 26.3 I 10.5 1 13,2 1 2.6 1 1 38
1 38.0
1 100.0 1 100.0 1 83.3 1 40.0 1 17.9 1 4,5 I
1
2 1 I 2 41 81 31
OMINANTMRTY I 1 1
I 1 11.1 1 22.2 1 44,4 ! 16.7 1 5.6 1 18.0
I 1 1 16.7 1 40.0 1 28.6 1 13,6 1 10.0 1
, -- -i • t " --- i +;
31 1 I I I 6 1 11 1
ONEPATY I 8 1 25
I 1 1 24,0 1 44.0 1 32.0 1 25.0
1 I I I I 21,4 1 50.0 1 00.0 1
4"-- I -"-----i .. -4------ 4- _ +
4 1 1 1 I 11 6 1 6 1
NW#-PATY MILITA I 1 1 14
I I I 7.1 1 42.9 I 42.9 1 7,1 1 14.0
1 1 I I 10.0 1 21.4 1 27.3 1 10.0 I
51 1 I 1I1 31 1
Nm-PFATY NHW I 1
I I 1 20.0 1 60.0 1 20.0 1 1 5.0
I I I
I - - - ----- I 10.0 ..-.
1 10.7 1 4.5 1
­ - ---- --- 4
I
COLUW 2 16 12 10 29 22 I0 100
TOTAL 2.0 16.0 12.0 10.0 28.0 22,0 10.0 100.0

121
 TABLE 14

-------------------- CROSSTA6ULATION OF ..................

CiOLSYS 'POLITICAL SYSTEM' BY COM[ 'GRIPED GROTH RATE'

CON6
cODEI
RON PCT 1-2,0-0.0 0.1-1.0 1.1-2.0 2,1-3.0 3.1-4.0 4,1-5.0 5.1-6,0 6.1-7.0 7.0 ROU
COL PCT I TOTAL
1 11 21 31 41 51 61 71 81 91
C.:OLSYS ' 4- itt.. '
I1 31 5I 51 71 81 5I 21 21 1 1 38
RI.TIPMTY I 7.9 1 13.2 I 13.2 I 18.4 1 21.1 I 13.2 I 5.3 I 5.3 1 2,6 I 40.9
I 25.0 I 38.5 I 31.3 I 41.2 I 53.3 I 45.5 I 66.7 1 50.0 1 50.0 I

21 21 21 31 iI 51 31 I 1 1 11 1t
Di)fIl$TPARTY I 11.1 I 11.1 1 16.7 I 5.6 1 27.8 1 16.7 1 I 5.6 1 5.6 1 19.4
1 16.7 I 1 .4 I 10.6 I 5.9 I 33.3 I 27.3 I I 25.0 I 50.0 I
i i, i --' i i ' i -t . . .+
31 41 21 51 71 I 21 1 1 1 1 22
SI18.2 1 9.1 1 22.7 1 31.8I 19.1 1 4.514.51 1 23.7
I 33.3 I 15.4 I 31.3 1 41.2 I I 1.2 I 33.3 I 25.0 I I

,i 21 41 31 2 1 1I I I I 1 12
* ,,AIl.TA I 16.7 1 33.3 1 25.0 1 16.7 1 8.31 I I I 1 12.9
1 16.7 1 30.8 1 10,8 1 11.8 1 6.7 1 I I I I

51 1 1 I I I1 1 II I I I 3
4-PARTY N-+ 1I 33,3 1 I I 1 33.31 33,3 I I 1 3,2
I 83z I I 1 6,7 1 9.11 1 1 1

COLLN 12 13 16 17 15 11 3 4 2 93
TOTAL 12.9 14.0 17.2 18.3 16.1 11.8 3.2 4.3 2.2 100.0
 TABLE 15

................ LROSSTARULATJONt OF
CW(LSYS 'POLITICAL SYSTD,'
BY CO...C. 'GRO..P....

CODEPCO
RON PCT 1*0-200 $201-400401-700 $701-100 41001-15* 1501-20 $2001-
40001-60 *60004 Rog
COL PCTII 1 lI 221 31 0 41 51 00 61 00 71 00 eI 91 TOTAL
CD .OLSY - ---- -"
11 4 1 5I 6 1 9 1 21 a1 3 1 11 38
KULTIPARTY I 1 10.5 I 13.2 1 15.8 1 23.7 1 5.3 I
21.1 1 7.9 1 2.6 I 40.4
1 1 22.2 1 31.3 1 .9 1 75,0 1 33,3 1 53.3 1 75.0 1 50.0 1
21 1 1 1 61 41 11
DOINAT PARTY I 3! 21 1 118
I 5-4 I 33.3 1 22.2 1 5.6 1i6. 1
I 1 5-6 1 3745 1 2M. 1 8.3 1 50,0 1 03.3 11.1 1 5,6 1 I 19.1
1 25.0 1
4t. ------ - - +- 1 "' t . .4 t - --- '-. -4 . .
3 1 4I 91 3 1 2 1 1
ONEPARTY 1 31 I1 22
1 18.2 1 409 1 13,6 1 91 1 4.5 1
1 3,6 I 1 23.4
1 57.1 1 50.0 1 19.8 1 14,3 1 8#3
1 1 20.01 I I
4 1 2 1 4 1 2 1 11 1 1 21 I 1 12
HM-PARTY HILITA 1 16,7 1 33.3 1 16,7 1
8,3 1 8,3 1 1 16.7 1 I
1 28,6 1 22,2 I 12.8
12.5 1 7,1 ,3 1 11 13.31 1 1
5 11 I I I I I II 1 4
NO-PRTY N-MI 11 14.3
25.0 11 1 1
1 1 25.01
M, 1 12 ,0
1 16,7 1 I
1
1 25,0 1 4,3
1 50,0 1
COLLw 7 18 16 14 12 6 15 4 2 94
TOTAL 7.4 19.1 17,0 14,9 12,8 6.4 16.0 4,3 2.1 100,0

123
 INTERNATIONAL MONETARY FUND LIST OF
TAX AND NONTAX REVENUE

TAX REVENUE

Taxes on Income, Profits and Capital

Gains

Individual
Corporate
Other Unallocable Taxes on Income

Social Security Contributions

Employees
Employers
Self-Employed or Nonemployed

Employers Payroll or Manpower Taxes

Taxes on Property

Recurrent Taxes on Immovable Property

Recurrent Taxes on Net Wealth

Individual
Corporate
Estate, Inheritance and Gift Taxes
Taxes on Financial and Capital Transactions
Nonrecurrent Taxes
Other Recurrent Taxes on Property

Domestic Taxes on Goods and Services

General Sales, Turnover or Value-Added

Taxes
Excises
Profits of Fiscal Monopolies
Taxes on Specific Services
Taxes on Use o-, or Permission to Use, Goods or to
Perform Activities

Business and Professional Licenses

Motor Vehicle Taxes
Other Taxes on Use of Goods

Other Taxes on Goods and Services

Taxes on International Trade and Transactions

Import Duties

Customs Charges
Other Import Charges
 Export Duties
Profits of Export or Import Marketing
Boards
Exchange Profits
Exchange Taxes
Other Taxes on International
Trade and Transactions

Other Taxes

Poll Taxes
Stamp Taxes
Other Taxes n.e.c.

NONTAX REVENUE

Operating Surpluses of Departmental

Enterprises

Property Income

From Nonfinancial Public Enterprises and Public

Financial Institutions
Other Property Income
Administrative Fees and Charges
and Nonindustrial Sales

Fines and Forfeits

Contributions to Government Employee Pension Funds within

Government

Other Nontax Revenue

CAPITAL REVENUE

Sales of Fixed Capital Assets

Sales of Stocks

Sales of Land arid Intangible Assets

GRANTS

From Abroad Excluding Supranational

Authorities
From Other Levels of National
Government

From Supranational Authorities

125
LIST OF DEVELOPING COUNTRIES IN ANALYSIS FILE

AFRICA

Benin
Botswana
Burkina Faso
Burundi
Cameroon
Central African Republic
Chat'
Congo
Djibouti
Ethiopia
Gabon
The Gambia
Ghana
Ivory Coast
Kenya
Lesotho
Liberia
Madagascar
Mal awl
Mali
Mauri tani a
Mauritius
Morocco
Ni ger
Nigperia
Rwanda
Senegal
Seychelles
Sierra Leone
Somal i a
South Africa
Sudan
Swaziland
Tanzania
Togo
Tunisia
Uganda
Zaire
Zambia
Zimbabwe

ASIA

Bangladesh
Burma
China
Fiji
Hong Kong
India
 Indonesia
Korea
Malaysia
Maldives
Nepal
Pakistan
Papua New Guinea
Phillipines
Singapore
Solomon Islands
Sri Lanka
Taiwan
Thailand

EUROPE

Cyprus
Greece
Malta
Portugal
Romania
Turkey
Yugoslavia

MIDDLE EAST

Bahrain
Egypt
Iran
Israel
Jordan
Syrian Arab Republic
Yemen Arab Republic

LATIN AMERICA

Argentina
Bahamas
Barbados
Belize
Bolivia
Brazil
Chile
Colombia
Costa Rica
Dominica
Dominican Republic
Ecuador
El Salvador
Grenada
Guatemala
Guyana
Haiti
Honduras

127
Jamaica
Mexico
Netherlands Antilles
Nicaragua
Panama
Paraguay
Peru
St. Lucia
St. Vincent
Suriname
Trinidad & Tobago
Uruguay
Venezuela
 CHAFTER V
SUCCESSFUL TAX INCENTIVES

Tax concessions and reductions

on a Piecemeal basis have
become an important tool in
attracting domestic and foreign
investment. The experience of Sri Lanka
is especially noteworthy
of the wholesale use of different
tax incentive instruments to
move its economy in the direction
of higher growth through
stimulating the development
of manufactured export goods.
Since
the election of Junius Jayewardene
in Sri Lanka in 1978, the
government immediately created
the Greater Colombo Economic
Commission (GCEC), which exercises
jurisdiction over 160 square
miles of land extending north
from the capital, Colombo,
to the
airport. Within this territorv, the
GCEC has established several
free trade zones that offer
investors a variety of incentives,
with no limit on foreign equity
participation. These incluue (a)
up to ten years of full tax
holiday on salaries, profits,
dividends, with a potential
extension of fifteen more years;
(b)
no income tax on the salaries
of foreign personnel; (c) free
remittance of dividends, no
exchange controls, and tax
free
status for non-resident shareholder
dividends; (d) free transfer
of shares; (e) no import duty
on raw materials, machinery,
and so
on. The GCEC goes out of its way
to eliminate "red tape" to
tall
investors.

By December 1982, the GCEC

hads approved 174 projects,
representing investors for
21 different countries. Providing

129
 employment for 25,000 people, the full developed
zone will employ
50,000 people. To see the importance of this figure, total

industrial employment in the entire country in 1979

stood at
about 150,000. In the first five years of operation of the
GCEC,
total foreign investment in the free trade zone
came to US$250­
:00 million. As a result of this economic program, industrial

exports rose substantially.

In addition to GCEC investments, a Foreign

Investment
Advisory Committee (FIAC) also authorizes joint ventures bptween

foreign businessmen and local equity participants.

Five!-to-ten­
year tax holidays on profits, dividends, and
non-residen-,
management fees are granted in a variety
of approved investment
or business areas including hotels, urban
development projects,
companies that construct power and irrigation
projects, pioneer
industries, gem exports, and so on. Total approved investments

by 1982 came to over $500 million and envisaged

new jobs from
these approvals are estimated at 67,000.

To complement the investment opportunities,

Sri Lanka has
established offshore banking in form of Foreign
Currency Banking
Units, which offer offshore banking facilities
to all non­
residents and GCEC enterprises. Permissible currencies include

French and Swiss francs, Japanese yen, Dutch

guilders, English
pounds sterling, German deutschmarks, and
US dollars. Profits
from the operation of offshore banking are
tax free. Total
assets and liabilities rose twenty times between
1979 and 1982 to
$650 million.

130
 Tax holidays to encourage investment
have been accompanied
by a variety of other fiscal relief
measures. Included are such
measures as exemption for interest
earnings up to Rupees 2,000 on
deposit with the National Savings
Bank (a measure to spur
savings), and exemption of up to one-third
of assessable income
if such income was spent on purchase
of shares in new approved
businesses, a contribution to a retirement
fund, the purchase or
construction of a house, or was classified
as a research and
development expenditure.

In 1980, both individual and corporate

tax rates were cut.
The maximum tax rate of 70 percent
on individuals' income was
lowered to 55 percent. Corporate rates were cut to 40 percent

for companies with publicly quoted

shares. Capital gains on
publicly quoted companies are exempt
from tax. Facilitating the
capital markets was the establishment of a
stock exchange, set up

on September 29, 1982.

These tax incentive measures have boosted growth,
output,
and employment. Since 1977, real rates of economic
growth have
doubled and increases in per capita
income between 1977 and 1981
have tripled compared with the prior
regime of Mrs. Bandara­
naike. These higher growth rates have been
achieved despite the
worse cyclone in decades, a worldwide
economic slowdown, oil
price hikes, and a severe drought.

Sri Lanka llustrates a list of possible tax

incentives and
concessions that are designed to
spur growth. A detailed list of
kinds of tax incentives includes:

131
 1. Establishment of a duty-free port without import duties

or export taxes.

2. The maintenance of low direct rates of taxation, and the

systematic reduction of steeply graduated individual tax rates or

high business tax rates.

3. An emphasis on consumption taxes to promote savings.

4. Granting of specific tax holidays to certain classes of

long-term investments.

5. Permitting accelerated depreciation to improve business

cash-flow.

6. Provision for loss carryforward.

7. Overall movement in the direction of greater tax

oeutralilty.

Additional Illustrations

The island-nation of Singapore vividly illustrates the use

of tax concessions to promote export-oriented industries. When

Singapore was expelled from Malaysia in t065, the newly indepen­

dent country was faced with a sharply contracted domestic

market. Singapore shifted quickly to the strategy of export­

oriented industrialization. The government turned to experienced

foreign companies to invest and manufacture for export. Compa­

nies were given a number of incentives to export. In 1965, they

were permitted to deduct double the expenses of developing world

markets fron their taxable income. A 1967 act granted tax

132
 concessions on profits earned
from exports. The consolidated
Economic Incentives Act of
1967 remitted 90 percent
of the
profits tax if export performance
was above a base level for
eligible industries. Existing industries seeking
to expand
could obtain accelerated
depreciation allowances and
extension of
pioneer status, conferring
100 percent for an additional
ten
years. The government treated foreigners
and foreign capital
eq ;zly with the local citizenry.
100 percent foreign ownership
of Singapore firms was allowed.
Immigration of necessary
business personnel .,as freely
allowed. Remittance of profits was
freely allowed. No controls were imposed
on capital movements.
In the 1980s, new incentives
were granted to encourage
research
and development work in high
technology industries, and
the
maximum personal income tax
rate was lowered from 55
to 40
percent (similar to the company
tax rate) to insure that
Singa­
poreans Oid noi view high
tax rates as a serious disincentive
to
continued hard work.

To summarize, the Singapore

government installed a raft
of
economic incentives to woo
foreign investors. Tax holidays,
"pioneer status," accelerated
depreciation allowances,
export
incentives, unrestricted
repatriation of capital and
profits,
relief from double taxation,
readily available factory
sites
accompanied by many amenities,
and subsidies for manpower
training programs. Many of the tax incentives
were appropriate
devices to compensate exporters
for the excess costs they
previously endured due to
a brief experiment with protectionism

133
 that prevailed prior to 1965. One can construe the offsetting

effects of these export incentives as moving the

tax system in
the direction of greater neutrality.

The Republic of China on Taiwan also adopted a series

of tax
incentives to facilitate a shift from import substitution
to
export orientation policies. When the United States government

in the late 1950s announced plans to phase out its massive

economic assistance, the government sought massive

infusions of
private foreign capital and technology.

In 1958, the government promulgated a Program for

Improve­
ment of Foreign Exchange and Trade Control. Accompanying a
devaluation of the New Taiwan dollar from a previously
overvalued
rate, the government undertook a number of concrete
tax steps to
compensate for distortions imposed on exporters
during the prior
import substitution regime. It gradually liberalized and finally

abolished the commodity import quota system. Tariffs were

reduced. Import controls were liberalized. It granted three­
year income tax exemptions to certain categories
of industries to
stimulate investment. It revised the Income Tay Law and the

Company Law.

In 1960, the government promulgated the Statute

for the
Encouragement of Investment. Key elements in the 1960 financial

reform package granted those export-oriented productive

enter­
prises, which met the scatute's criteria, a five-year
income tax
holiday, set the maximum rate of profits tax (including surtax)J
at 18 percent, compared with the ordinary 32.5 percent
rate,

134
 allowed all reinvested undistributed
profits to remain free of

tax, give a tax deduction for exports equal to

2 percent of
annual export proceeds, exempted
or reduced productive enter­
prises from stamp taxes,
and permitted 7 percent of
profits
before taxation to be set
aside as a reserve against
losses due
to exchange rate revisions.
Annual .ax refunds due to
these new
incentives, as a percentage
of tota. income, stamp, customs,
and
commodity taxes, ranged from
a low of 19 percent in 1963
to a
high of 52.4 percent in 1972,
with the annual average in
the 30­
percent range. Taiwan's remarkable economic
growth, in part, is
directly linked linked to
these sharp reductions in
taxes.
Adding more of a good thing,
the government revised and
expanded the scope of the
investment statute in 1965,
authorizing
the creation of duty-free
export processing zones.
Three zones
grew so fast that by 1970
they provided 7 percent of
all jobs in
manufacturing and turned
out a tenth of all exports.
In some
years, the entire balance
of merchandise trade could
be traced
wholly to the trade balance
within the zones. A necessary
accompaniment to an export
strategy was the steady reduction
in
the rate of protection provided
by tariffs throughout the
1960s
and 19 70s.

Additional incentives included reimbursement

of customs
duties and harbor dues imposed
on imported contents of export
products, refund of the commodity
tax on products for export,
extension of foreign exchange
loans for the import of raw
materials for export processing,
extension of low-interest
export

135
 loans, exemption of income tax
and business tax on export
transactions, cash bonuses for
exports, establishment of bonded
warehouses, and export processing
zones. In total,
these tax
concessions for exports neutralized
the prior bias of Taiwan's
import substitution period between
1949-1960.
Another set of incentives is found
in the rapid industrial­
ization of South Korea (hereafter
Korea). Apart from maintaining
an effective free trade exchange
rate through using export
incentives to offset domestic inflation,
the Korean government
implemented a series of trade liberalization
and tariff reform
measures. Exporters were granted
preferential credit. Other
steps included indirect tax exemption
on inputs into export
oromotion and export sales, a 50
percent reduction on income
, from export earning5, tariff exemption
on imported raw
'Ierials and equipment for export
production, and a "wastage

",owance" on imported raw materials for

production of exports.
o!Iowing
. the example of the successful Kaohsiung
Export Process­
ing Zone in Taiwan, the Korean
authorities passed legislation
creating several tax-exempt and
duty-free zones of their own in
the late 1960s, which generated
tens of Lhousands of jobs in a
few short years. These measures should be viewed
as moving
Korea's overall tax system in the
direction of greater neutrality
to compensate for the bias imposed
during the import-substitution
phase of postwar Korean development.

A final example is the case of

Brazil (1958-1964), which for
a brief period of six years outgrew
each year the four Asian

136
 hyper-growth economies of
Hong Kong, Taiwan, Singapore,
and
Korea. Incentives were improved
by eliminating the tax discrimi­
nation against exports of
manufactured goods, and the
introduc­
tion of various export subsidies.
Second, rates of import
protec, aon were reduced steadily
between 1968-1973. By 197Z, the
average tariff on manufactured
goods stood at about 57 percent
of
its 1966 level. Exemption from federal indirect
taxes enhanced
the profitability of exports.
Exports were then exempted
from
state indirect taxes, taxes
on financial operations,
and the
special tax on fuel and oil.
These measures were largely
aimed
at eliminating prior tax
discrimination against exports,
thus
moving the system towards
greater neutrality. From
1968 on,
export subsidies were granted
in the form of federal and
state
tax credits, exempting export
profits from income taxes,
and
preferential credits for
imported inputs. To repeat,
subsidizing
exports involved superimposing
a system of export incentives
on a
system of import protection,
which tried to neutralize
the
adverse effects of an overvalued
currency and the higher costs
of
domestic inputs into the
manufacture of export goods.
These case studies of tax
incentives demonstrate a
wide
variety of successful reforms
that have been employed to
stimu­
late foreign and domestic
investment, spur growth through
more
efficient allocation of resources,
and enhance the supply of
labor and capital by increasing
aftertax returns.

137
 Ki0 N'U-,
rl ",i-
60 -- 60

50F-.TP MARG. TAX RATE: SOLID LINESYMBOL X

TOP TAX BRACKET-DASHED LINE,SYMBOL DIAM0ND 50
- --
I- U

40
x -40

30 -30
z c:

<-
r-1 20 ­ . . ...... - 2
20

-- 010

0 0
1960 1965 1970 1975 1980 1985
YEARR
 SINOARPh7

300 OP MARG. TAX RATE: SOLID LINESYMBOL

X
w-
TOP TAX BRACKET:DASHED LINE,SYMBOL
DIAMOND3 300
LF­
-u

"20
-03
F-200
20 o

CD
0 Z
F- -
-
z--
100 -­ ...

.................
.. ......................
........
1960 1965 1970 1975 1980 1985
YEAR
 - i A

100 -100

80 80­
IF%IM OX )-
_l --4

-
x 60 --60 -u
H- TOP MAR3. TAX RATE: SOLID LINE,SYMBOL X
TOP TAX BRACtZETIDASHED LINE.SYMBOL DIAMOND
7 ()

40 zm
4040
5_ - o-o.
m

- 20 ._-20

0 t~ic"

0
1960 1965 1970 1975 1980 1985
YEAR m.
 INDONE-SIA
80 TOP MARG. TAX RATE: SOLID LINE.syMBOL
X
TOP TAY BRACKET:--ASHED LINE,SYMOOaL
80
DIAMOND

70
70
LU­

- 60
60­
x
-F-

CD--
'

<
rY 40-­
40> 0r
CD
30-
30

20J20
1960 1965 1970 1975 1980 198520
YEAR
 100
100
TOP MARG. TAX RATE: SOLID LINE,SYMBL "
TOP TAX BRACKET.DASHED LINESYMLIOL DIAMOND

Lw 80
80
-H

C., _."
;u
--­

< 0
6J >0
X" 10

2 0 1 -1 - 1- ." ". 0 3

20
,---
,
. .X

1960 1965 1970 1975 1980 1985

YEAR
 PORTUG AL

100
-00
II.
LLJ
II

x 080.
/ x. - - . ­­
-- 80 >0

Cu

CD G0 m

40 ----
TOP MARG. TAX RATE: SOLID LINESYMBOL
X
TO P TAX BRACKET:DASHED LINE,SYMBBL DIAMOND
( "
4440. 0 C:

20 .. .I , , , , I , ,
1960 , I , , , 20
1965 1970 1975 1980 1985
YEAR
 80 80
TOP MARG. TAX RATE, SOLID LINE,SYMBOL X
TOP TAX BRACKET:OASIIED LINE,SYMBL DIAMf ND

70 70
LLI

I- 15 -
I-
X -­
•< ---­"E cc

50 x.
.. x* -50

< 40- CDD 40

30. 30

2 o ' ' 'I , , , ,,, I

II,I , , , ,, II I , I 2oj
1960 1965 1970 1975 1980 1985
YEAR
 CHILE
00-
,100
TOP IARG. TAX RATEI SOLID
LINE,SYrIBOL X
TOP TAX BRACKET:DASHED LINESYMBOL
DIAMOND
80-
8 0
<
<- G00 ­ . x.... / .>' 60

<0 40
Cl _ ­ c0 . . . . . "
20-­
20
20

0
0
1950 1965 1970 1975 1980 1985
YEAR
 JAMAICA
80
--80

<F
....-­ x -0
ly-U
-t

TOP MARG. TAX RATE: SOLID LINESYM(IL

X
TOP TAX BRACKETDASHED LINESYMBOL
DIAMOND
-40 40
40--;
CD
ry
F-l
- -­

CD20
20 0­
-
0

f~I..o

1960 1965 1970 1975 1980 19850

0 - YEAR
 80
ST= VINC-NT
r OP MA9G.
TAX RATE:
S'7-D LIlNE,SY'BSL
TOP TAF,BRACKET:DAS'-. LiNESY -1 L :0<..
0

0
i-1
ii' 60---
I
X
<
' .I- . .. -- .._J
460
-- 0'
(_D 117
44
~[71
(U)

nO_

20-0
20 o

....................................
..... .>
1960 1965 1970 1975 1980 1985 0
YEAR
 .- 'ANA
80 OP MARG. TAX RATE: SOLID LXESyh.L
TCP TAX BRACKETIDASHED 80
LINE,SYMBOL
DIAMONo

-- ,0
"x ...... x -60

< -40 xx
zX

5- CD m

20

20 0

200

160 1965 1970 1975 1980 19850

A R
(C
 D,,,UDAN
80 TOP MARG TAX RATE: SOLID LINF.YMROL
X
80
T P TAX BRACKET:DASHED LINE,Sy,1B
L DIAM ND
1- I

kLJ
-­
F- 60L
< -60
-
x
CTD

-\

20
20- 0
-02

20

1960 19655 1970 1975 1980 1985

YEAR
 TOP MARG. TAX RATE: SOLID LINE.3YMI30L
TOP TAX BRACKET:DASHED LINESYMP0L X
DIAMOND

80 -80
F- ~ "" "" .............................
LLI 80
X-­
I-- CD

< X

.,0,

40-4
C! 40 ;
7-
-

20-
", -­20
20 c0

196g 1965 1970 1975 1980 1985 0

YEAR
 ZAIRE
TOP MARG. TAX RATE: SOLID
LINESYMBOL X
TOP TAX BRACKET:DASIIED LINE,SYJMD(AL
DIAMOND
60 -
...... . 60
I-
LL _- -*".°
- X - -­

40
-J>­ -4 0 (-u
CD-

CL
20
2020
H-
C)
CD

0
0
1960 1965 1970 1975 1980 1985
YEAR
 TIP "ARG. TAX RATE: SOLI0 LINE,SYMBOL X
TIP TAX BRACKET:DASHED LINESYMPOL DIAMOND

80
80

.x.
x 60 ,0-"
F-U

lu

z
0::
C5 40 -. ,
40 -

aI -­ I " 0
CD
\ ""0
I-
20 . .CD

20

I I I II. .. A • -
960 1965- 1970 1975 1980 1985
YEAR
 KENYA
80
80
x .
E LI
X . . . . X - . . . . ._i

< G0
f6G TOP HARG. TAX RATE: SOLID LINESYMNBL
-
X

< TOP TAX BRACKET-DASHED LINE,SYMBOL DIAMOND

- 4 CD­
40 m
n__I
2-­ .-
o/ \0­ _@

-
0
20..
- 20
09-­ 6 ". ............. _

1960 1965 1970 1975 1980 1985

YEAR
 70 -TOP MARG. TAX RATE: SOLID UNE.SYMBOL x
70
TOP TAX BRACKET:DASHED LINE.SYMBOL OIAMVJ.Jl

ULJ

I<- 50 - ... 50 -13

-
z- -
< 40.. .
-40
C

CD - Frl
0 -
<30 - 3"0 x
20 0
--3.
0- CC -2

10
1960 1965 1970 1975 1980 1985
YEAR
I--
 PAKISTAN
TOP MARG. TAX RATE: SOLID LINE,SYMEOL
X
TOP TAX BRACKET:OASHED L!NE,SYMC"t
-t'IAMOND
80
w-., 80
,,, . ,
H8

'<:: I "x
-- -x . - -)
('I

x-S660
.. 6 w--
-­

40-
40:

x
20- 0
** 20• ­
0

/J

1960 1965 1970 1975 1980 1985

YEAR
 10 0 -
TOP IARG. TAX RATEI SOLID LINE,SYiBeOD -- 100
10
X
X ...... X
-TOP TAX BRACKET:DASHED LINE,SYMBOL DIAMOND

80
80
I-w -
X
.J
60-6
- 60 60
<2 J

CD
-im
37 40
40><
I- -"-( CD 0
)
CD
20o
20

19 0 1965 1970 1975 1980 1985

YEAR
cv
 Additional References
Bagchi, Amiya Kumar. The Political EggngMy g Undrvlmnt. New
York: Cambridge University Press,
1982.
Bauer, P.T. Dissent on DeveloRMLeat.
Cambridge: Harvard University
Press, 1972.
----. •RAIity and Rtorjc:
Etudigg in the ECgngmic& Of
P RY212Mnt- Cambridge: Harvard University
Press, 1984.
Bird, Richard M. Taxing g
i LYCRIfLag Qu at jakrsr.
Cambridge: Harvard University
Press, 1974.
Block, Walter and Walker, Michael,
ads. Taxatign: An InkErjantig2ag1
ER 229tim ". Vancouver: The Fraser Institute,
1984.
Brunner, Karl, ed. The ElCut
WGC & tha Iblcd WCld. Rochester,
NY: University of Rochester,
Graduate School of Management,
Center for Research in Government
Policy and Business, 1978.
Chenery, Hollis B. "The Structuralist
Approach to Development
Policy." American Economic RevjRV 65(May
1975): 310-16.
Comeliau, Christian. Inter-dR 2 en2
0 c92 8a0_ ttrE gi p.mgat.
Parisi Organization for Economic
Co-operation and
Development, 1985.
Crockett, Joseph P. "Tax Pattern in Latin America."
N n0 I
Jour0a 15(March 1962): 93-104.
Dominic, M.P. In9gR ISiKAULgn * Egumlg Ie ant 1n
LEI miggjcj
CountEIRS. Amsterdam: International Bureau
of Fiscal
Documentation, 1980.
Ebrill, Liam P. "Taxes and the Cost of Capital.
Some Estimates for
Developing Countries." Washington: International Monetary
Fund, Fiscal Affairs Department,
DM/84/16, 1984.

157
 Friedman, Milton. "Economic Miracles." Newsweek (January 21, 1974):

80.

"Myths That Keep People Hungry."

L C'2 (April 107):

16-24.
Gandhi, Ved P. "Tax Structure for Supply-Side Economics
in
Developing Countries." Washington: International Monetary Fund,
Fiscal Affairs Department, DM/85/1,
1985.
Haberler, Gottfried. "The Case for Minimum Interventionism."
In
Foreign Aid Reexamined: A Critical
AgnEaiE a, edited by James W.
Wiggins and Helmut Schoeck, 139-50. Washington: Public Affairs

Press, 1958.
Heller, Jack and Kauffman, Kenneth
M. Tax Incentives for Indistry in

! p y2g'Md g tCjR*. Cambridge: Harvard University Law

, International Tax Program, 1963.

VIS Harley H. A GgCg ItG~ gi IAK gt~tC Qtg ~Uing

U fi2MU-. Crmbridges Harvard University
Law School,
international Tax Program, 1966.

jaytng j,In Q egg2jag QgUIrCjMq, 5th ad. Paris: Organization for

Economic Co-operation and Development,
198:.
Jacoby, Neil H. "Taxation in Lao.. Policies for a New Country With
an Underdeveloped Economy." L1jgna Ia i Jg~inpa 14(June 1961):

145-62.
Krauss, Melvyn B. 2 2j2hgit! a d. New York: McGraw-Hill,

New Press, 1983.

Landau, Daniel. "Government and Economic Growth in
the Less
Developed Countries." In SaeutnEd Ep , 17-62. Washington:
President's Task Force on International
Private Enterprise, 1984.
 ----- "Government Expenditure and
Economic Growth: A Cross-Country
Study." South22 Econic Journa 49
(January 1983): 783-92.
Lewis, Stephen R., Jr.
Taxation for- De-gent.
New York: Oxford
University Press, 1984.
Little, I.M.D. Econoig Devel o2Mgnt:
IhgE,
h oljcy gag
Internati nal Relations. New York: Basic Books, 1982.
Mackenzie, George A.
"The Macroeconomic Supply
Effects of Tax Rate
Changes." Washington: International
Monetary Fund, Fiscal
Affairs Department, DM/83/2,
1982.
Marsden, Keith. "Low Taxes Signal a Healthy
Economy." Wgll gtrpgt
Journal (December 16, 1964).
"Why
-. Asia Boomed and Africa Busted." Wall Street Journal

(June 3, 1985).
McIntyre, Michael J. and
Oldman, Oliver. Insttutionalizing thg
Process of Tax Ref orm:
A CorgaCativ Analysis. Amsterdam:
International Bureau of Fiscal Documentation, 1975.
Poats, Rutherford M.
D l-R
e g. v Paris: Organization
for Economic Lz-aperation
and Development, 1964.

Prest, A.R. Public Finan__ in Devel

oinq Qggant ies, 3rd ed.
New
York: St. Martin's Press, 1985.
Shaw, G.K. "Leading Issues of Tax
Policy in Developing Countries:
The Economic Problems."
In The Political g g±I ijtn,
edited by Alan Peacock
and Francesmco Forte, 148-62.
New Yorks
St. Martin's Press, 1981.
Smith, David. "Public Consumption and
Economic Performance."
National Westminster Bank
Quarterly Review (November
1975):
17-30.

159
Stern, Nicholas. "Optimum Taxation and Tax Policy." Washington:
International Monetary Fund, Fiscal Affairs Department,
DM/84/9,

1984.
Tahari, Amor. "The Impact of Taxation on Saving and Consumption
in
Developing Countries: A Paradox?" Washington: International
ilonetary Fund, Fiscal Aff-irs Department, DM/79/21,
1979.
Tanzi, Vito. "Tax Policy in Middle-Income Countries: Some Lesson% of
Experience." RARi f gC .1attCukL2n Eluaal Dgmm a
36(August/September 1982): 411-20.

..... • "Tax Systems and Policy Objectives in Developing Countries:

General Principles and Diagnositic Tests." Washingtoni

Intarnational Monetary Fund, Fiscal Affairs Department,
DM/83/78,

1'?'3.
...
.. i, Sub-Saharan Africa. Washington: Intarnat onal Monetary

"rf, Occasional Paper No. 8, October 1981.

"'vlson, W. Scott, ed. ITh Th;.-d Wgrzj!: 3ise gf

f.. gi ­
!ian Francisco: Institute for Contemporary Studies, 1978.

Tolley, George S. and Shear, William B. "International Comparisons

of Tax Rates and Their Effects on National Incomes."

In
IntqCnjqU&a QCgmRAijgU gi ftgggtivity Causes fgthe
SlowdgV0, edited by John Kendrick, 197-225. Cambridge:

Ballinger, 1984.

160
 SUMMARY OF COMMENTS BY EXPERTS
USAID CONFERENCE ON TAX POLICY
AND ECONOMIC GROWTH
Panel I - Macroeconomic Policy

Stuart Butler, Heritage Foundation:

If one examines the Rabushka-Bartlett

perspective of the experience paper from the
in depressed regions in the
States, some interesting observations United
arise:
-- small enterprises are at
the heart of job generation
and
innovation;
-- indirect taxes are more burdensome
to entrepreneurs than
is direct taxation;

-- the availability of capital

is related to the tax
treatment of investors;

-- business decisions are significantly

influenced by the
manner in which tax revenues
are spent; and
-- local tax rates are not- very
high on the list of factors
determining a firm's decision
to locate in a particular
place.

These similarities may allow

Rabushka-Bartlett findings. for some insight into the
A reasonably high threshold
taxation allows small entrepreneurs of
to accumulate capital while
high marginal rates at only
high incomes may not significantly
inhibit economic growth -- indeed,
if relief from thes high rates
is given for investment, there
may be a net boost to business
formation. Moreover, if tax
revenues are used to improve
basic infrastructure for business, the
countries with relatively high
tax rates may also experience
high levels of economic activity.

Vito Tanzi, International Monetary

Fund:
The tr"Jitional view of developing
countries holds that:
-- high incomes do not originate
from work effort or
entrepreneurship, and thus could
be taxed away with little
negative effect;

-- high incomes result in high

consumption and/or capital
flight;
-- government can generate a
high rate of saving by raising
taxes while holding down iLs
own consumption;

16&i
 -- because of the lack of knowhow and initiative, government
had to take the lead in carrying out investment;

-- the negative effect of taxes on labor supply could be

ignored because of the overabundance of labor;

-- private investment in desirable sectors cold be stimulated

through the use of specific tax incentives; and

-- there is little evidence that marginal tax rates are

important in determining the propensity to save, invest, or
supply greater effort.

Each of these assumptions have proved faulty, as follows:

-- large incomes are often more the result of implicit taxes

than of property ownership;
-- the assumption that high income inevitably results in high
consumption has been challenged in theories of consumption
function;
-- governments are unable, foL the most part, to resist
pressures for higher public consumption or for politically
determined investment projects;

-- goverment does not have a monopoly over knowhow or

initiative -- a country without entrepreneurs in the private
3ector is not going to produce them in the public sector;

though overall labor supply may be abundant, the abundance

does not apply to the supply of skilled workers;

-- investment incentives may stimulate less investment than,

lower corporate tax rates; and

-- taxation may have negative effects on the propensity to

save, invest, and work harder.

These changes would seem to argue for a reduced role in the

public sector of the economy. We should scrutinize, more than
we
have in the past, what the public sector does. We should shift
the "burden of proof" from the market to the public sector.
Implicit taxes in particular should be closely examined. They
breed corruption, misallocation of resources, and e-ntually
lead
to the creation of black markets.

The goverment must simultaneously begin to pay closer

attention Lo the level and composition of public expenditure.
Policies in the spirit of supply-side economics must aim at
reducing public expenditure. The role of public enterprises
must
be reduced, and some should be privatized or simply shut down.
 Finally, the role of subsidies
must be reduced.
Only when the ratio of public
expenditure to GDP begins to
fall, would I pay attention
to the proposals to reduce
made by supply-siders. Moreover, tax burdens
in reducing the tax burden one
would want to attack those
taxes most damaging to economic
efficiency. These are not personal
income taxes, but foreign
trade taxes.

A major mistake we could

to sharply reduce taxes before make is to tell developing countries
making these other changes.
move would aggravate current Such a
problems and would lead to
inflation and greater balance higher
of payments difficulties.
maximum marginal tax rate of The
the personal income tax is hardly
important a variable as it as
is made out to be. Its reduction,
seclusion, would not have significant in
permanent effects. The real
importance of the marginal
tax rate is symbolic. It can
thought of as a proxy for the be
other policies necessary for
sustained economic growth.

Geraldo Sicat, The World Bank:

I am in sympathy with the view

to perform better than a regime that the market economy seems
of controls. This is a result
the last fifteen years of research, of
which show that controls often
lead to unexpected distortions.

A colleague and I recently studied

developing countries. First the tax rates in fifty
of all, we found that the top
brackets do not tell us anything
very meaningful with regard
effective rates the average to
person in a developing country
be facing. In trying to establish such would
an average, we asked two
questions:

--What is the point at which the

individual is required to
pay a tax?
-- What is the point in the income stream that the top rate
affects?

As to the first question, we

times the average per capita found the average to be three
family income. The top rate begins
to bite at between 30-50 times
family income. Thus, such rates
apply to only a tiny fraction
of any developing country
population. In fact, our studies
taxed less. show that poor countries are
The overall tax rate for our
percent. Rut when the industrialized fifty countries was 40.7
removed, tihe average fell to control countries were
12.8 percen%. I think these
meaningful results, but I leave are
it up to you to make judgements.

163
 Richard'M. Birdivriyo 'ono -o

The-subject of tax, p601i and groWth has,,been e'xhaustivelyv

~dsussed iYn both deve16kedaddyeorgouti'
-an~dw e do'~no t rea1'1y kr "ow r yerb Lj;;:<
setting. ,iUndotbtedy~hr be0~f
orts4
n'gro'wth4V' . D~~% tsmy a
Ut i t i s, highly 1stoo-"
d'qetoabe'-t _jto '"', ,
~s miibpl c Co16s lons f rm. 'thie' l1imnied daa',ava1l able. In draw
W1 1 .pres'ent, 'a 'brief story that ma s, ead
I )ns ights.
rviesm more general ­
' ~ ~ -~)

~The stbr~~
~
Ipercefltage 0ffGDPijje11b e ountry~(c
cu'y foy
11. it G))in
p(-cdh
w~hich~ takesa a '--

in' fivef ,years.

Thd -ii wa'-u
uCt ions. If we' takethe. R 'b---Iur-p
.~ed
throi pointml
ur
.

f departure, we would~ exet such acountry to~ be' averitab e; --­ ~~~
fscalpars e;~ partculdr y- 1j 1 point out,
Ofru&DP wa 'taeninr~ that' only~ 5,i e en
taeWiate ed ft' p.~o 18
ruthaEth t axa
er-$5,00,' poo s.Prcnt'nici
ad m inistra
.,poor~~~~ saio' o k e''aonfnms
kesot.6rnings'-ou.t
tax ',net., Morevr all t noitt-Jus; those~o 'f the~-~­
\incm have
bendcihn stveail iotaer ',hi pero d Unotua eythe~
Cj)owt
r,,te inta f'nraigra ight bie expected, decjiied,

(,t iro sin;t

growh fell~ beause taxes~~~
~
14L. e~i~ithei
In facth ervu dI.Aa
ldpie, dlth&: usionsia .~owh,
conc uionh g oth-'
r n fat, JI0 o 't, e, ayeason 0ezpect
o that the'
' ­

~~,mewould: have been different~had tegverlnment

;,ace. r t&o 1:}percen Cjnstea-~ of 8 pe;" ert., -- The,'poinr~tthe t op
-~---- ~i~~;th and p6iticaI environmn is is'Y­
nire~
.,moi
Po~c~rtant in~every ,,espect ITococe I il
'~tanidai"' s'%em
~te fro' per spec ti.ve k growth iii~ lo.ok

lite'oi7otaxation~,f poIts 'norder not to

e-cura6entrepreneursip0; -
,

',-*'~ ~-littl or no taxation of undstrib~uted profits-

Sview ofl underdeveloped',-pit-l rin- , . ­
r--
- 4"-­
-' taxes, aimed' at discouraging consumption relative
in 'order to
i~-
t bs'vi
encourage the latter; -~­

77'!taxes 'with- margina'l rae o rltv to avrg

-der. o- r- t~o'encourag rae ;in
, w o~r k e-­
-. 7 '11i tt l': o' r, no a- he
n ioo n the- very poorest. people', who.ne
an,:adequate level cnuipi t be productive,,- "'':

txstat are stable ,to" fEac 1ia -,on buaes"ss~,~

'; d~c ~~s;
o-oud'bisi
n ;

q1-V
 -- taxes that are well administered,
especially in the non­
monetized sector.

This "supply-side"
Carl Shoup over twenty prescription was outlined by Professor
years ago. As he noted
characteristics of existing at the time, the
tax systems in LDCs
close to some of those are surprisingly
prescribed above. Most levy few effective
taxes on profits (especially
undistributed profits)
capital. Most levy few, if any, or income from
consumption much more taxes on the poorest.
heavily than saving (at Most tax
explicit systems). least through their
Many even have low marginal
and fairly stable legislation. effective rates

Shoup concluded
equals, avoidance of that other values -- "equal treataernt of
socially dangerous concentration
promotion of a rational of wealth,
tax conciousness" --
by tax systems in LDCs, are being sacrificed
as opposed to growth.
better description of This may be a
reality than the tax-choked
emerges from the Rabushka-Bartlett growth that
study.

Panel II - Tax Policy

Gary Robins, CSIS:

How do we identify tax
less economic growth? policies that have encouraged
This is an extremely more or
Here we were presented important questioen.
with a cross section
so, its seems that of countries, but even
we really need to put much more
developing a consistent emphasis on
or complete systematic
to analyze these kinds framework in order
oE questions.
In my case, what we have
capital accounts so done is develop a detailed
that we can try to take set of
dealt with business care of questions that
taxation -- both corporate
In order tc get at this and noncorporate.
question of the threshold
marginal rate, we have had to put together versus the top
an individual at least a brief cut as
tax model
data, and on too of that that has traces of time series of panel
you need some sort of
general equilibrium framework noncontroversial
question. For instance, within which to look
at this
we put up a simple Cobb
production frontier Douglas
and a simple Cobb Douglas-like
those are the only behavioral household, and
else is basically taxes. equations in there and
everything
The problem with trying
kind of analysis to worldwide to apply this
system is that it is
extremely hard
to get firm data.
An enormous amount of
sorting the necessary work is involved in
data, and this work le-iel gathering and
discourages most investigators. greatly
But that is the kind
we have to do and we of work that
have to tackle it systematically.

165
 Richard Goode, The Brookings Institution:

If growth were the only economic objective and

leaders of developing countries believed that minimalthe political
activities were most conducive to it, their choice state
of tax policy
would be obvious: keep taxes simple, non-progressive,
higher than necessary to pay for the few functions and no
that all except
philosophical anarchists agree must be performed
by the state.
But governments have objectives in addition to growth,
political leaders and development economists think and both
that growth can
be assisted by public expenditures.

The main economic objectives of developing country

governments are grwoth and development, stability,
equitable
distribution of income and wealth, and national
independence or
self-reliance. Any one of these objectives, if
pursued too
vigorously, is likely to conflict with the others,
may have to be faced much earlier than enthusiasts and trade-offs
expect.
The main theme of the Rabushka-Nartlett paper
taxes are favorable to growth. The consequences is that low
of low taxes (in
-relation to national income) can be meaningfully
discussed only in
conjunction with government expenditures. Unless
accompanied by
low expenditures, low taxes mean inadequate revenue,
±inflation and excessive borrowing at home or abroad, leading to
with
; .. on growth and other economic objectives. Even if harmful
.- one is
. .i6 that a small government budget is desirable,
it would be
.uy :o recommend that a government move toward
it by first
" '..nf taxes.

R:l'zushka and Bartlett cite the history of Great

'x United States in che nineteenth century as Britain and
evidence that a
*.LD--ta -small-budget policy is consistent with
rapid development.
But prevailinq ideas about the rPnnnqhi1ia M: 4--k- .&.&- &-_
 interventionist. Brazil, also
mentioned in this context, has
extensive state intervention
in the economy (and high taxes
As far as equitable distribution, too).
Kong and Brazil have highly the evidence is mixed. Hong
unequal distributions, and while
Taiwan and South Korea are
less unequal, this is probably
result of agricultural land moce the
reform than tax policy.
I think the research has been
with the individual income tax, disproportionately concerned
international trade and domestic as compared with taxes on
example, three fifths of total consumption. In 1980, for
central government revenue in LDCs
came from the former, while
only
Rabushka and Bartlett's research one fifth came fron, the latter.
analysis of indirect taxes and needs to be supplemented by
an
corporate profits taxes and
examination of special investment by an
incentives.

Oliver Oldman, Harvard Law School:

Identifying appropriat, tax rates
equity varies from country for economic growth with
to country and can only be done
of an overall evaluation of as part
a country's economy. More important
is effective administration
and collection. USAID, with
cooperation of the Internal the
Revenue Service, has been a
assisting developing countries leader in
to modernize their tax
administrations including collection
were dealt a serious blow when techniques. These efforts
the U.S. failed to implement,
indeed, repealed much of the
legislation dealing with income and
withholding on dividends and tax
interest payments.
At the same time that virtually
modernizers strongly urge the all tax administration
of extensive withholding sytems, careful design and implementation
own limited attempts to do so. the U.S. is recoiling from its
That message is a form of teaching
by one's own actions and is,
unfortunately, spreading like
wildfire. The world is witnessing
most effective means yet devised the dismantling of one of the
for international tax compliance.
The substitutes -- more intrusive
reporting, and severe penalties government measures in terms
-- stand little chance of success, of
and seem just the opposite of
what those who favor less government
regulation would wish.

As to the Rabushka-Bartlett
paper's conclusions:
-- I agree that "greater prosperity
go hand in hand in the developing and larger public sectors
as well as developed
world."
-- I agree that it is worth
noting that "a slightly higher
fraction of high-tax countries
rank better on political
rights."
-- A fuller examination of effective
those measured as a percentage corporate tax rates -­
of income after normal

167
 ~'-4'

S depreciation and other deductionsU would sho w',a,

consierabl~e~e amii<le devlpn countries.
- The final sentence of th paper greaterprlac -­

.jiret reineo
efcitmt ahxes h or ,o wth an-~rser y ­
ampotrm th re despread agreement tha c- m~
evax'hva an'
imprtat ole in,the process~off growth.
It snot%,difficult to agree that !,the key to a sound~- '

system 6of'direct aation is?~toiiintain low top m'rgn

rates 1on h'ig~ hrsi~so~hc h ig hest rat"
Disagreement will,4r'is, -nthieinterpretation o lw"1
rnarginal': rates; btL mjv1inclination has been t'o start with, the
propsi in tat - 5 0,percent i s neither too hi4gh: nor too 1w.,~

W--' 'My'concl'us ion isfthat'isfa.a th per ttstruths, . ­

~their: ri~rto'\ iq 6'e But'Ratjshka adBartle'tt 'd6 not
~, of fe suggestions1 whi hwodhl inthehrwork
4 w b'd i d
o~ modernizing
hel ' T~"e hei 6 'm'

~ the tiax systems of dvl'oping, conre s~ th the

objec ft frnss, eficiency ndsmp1±citywhile 4striving"4
/"fffor-economic,. sociarwth equ ty. W
Hwrd, Pak e.

~-~Owad~PckSvarthbre.,College
9
.. any. ec~rwth. In
II t.- a cLimorssi esoen mag t at' getting'rid 'of [di'stortfons,
a ocy hgh w1aeki1l;.have anything- 1rnmore ithan- a' 1 /f0thA.
6-r C'e nt 'increase on'4GNP -on ~a 'once-and-f &r-ali -basls. I,~ .,

~~"'~~Q(~~1-~~d
m wpsatat ecisve r~y 'ow
14f 1at-tax rate ,in
1,01 S, o' I an ma e:hesr ucture' an oe
of whch 'would' ­
Stuirn up'large npa t s eof:phersona income tax.

We;Zhav no emiiaIev
, ~ eta savings rates are 'very -- 'A'kV
resos ivvetoafter-tax, rates,in" LDCs t-he. effect 'is probably'-­
jc 16os e'' t' -zero abrfregrw'oth 'is la rg'ely a f unct ion of, '­
ppu1a t ion wth. On prodictiyi'ty, g rowt
pfatrei exten bf 0te think '-t h e decisive -4
eas uethextnt f cmpet'it'iveness in'hj
Serscnial1;income taes FialId' o.tn not
'entrepreneurs'h ie issrosyafced y ''snltax rates.~LDC~~
enrpeer hav inopaind t m about cointroils, qguotas 'and the'->- ''L4
"

~like, ut1ever, pers onl'nm taxes

If 'all economic disortins wer'e removed simultaneously, GDP~ ­

4c0Li be increased 3*5' ce'he 'n--sits. ba' But'all &~f' "

'P the obstacles not just-hih ' x r'a~e 77 would 'hav6'. t o'' be'
--

r4 e" v~~ a -e 4'4' "4 4-,tq -'

ro!Atgehr~­
-i ~ ~ 8{ - '' 4' - V,.A16
 Panel III - Compliance and Equity

Sidney Weintraub, University of Texas at Austin:

AID operates primarily in the least developed countries, not

in the NICs. And, therefore, if you are going to focus on
AID~s
kinds of operations, you have to focus on Africa and the other
very poor countries in other parts of the world. By definition,
these countries have less abundant trained personriel, and
inferior
human and administrative infrastiucture. Income taxes hardly
matter in these countries at all, but you still want to keep
the
tax structures simple in thes countries. You have to think
in
terms of ease of administration and collectibility.

AID is an operational agency, and it's no longer a critical

donor in most developing countries. What I am saying is that
AID
is limited in its leverage, and that you really need
conditionality in lending. AID must therefore depend on the
leverage of others. I think AID must focus country by country, on
distortions in the explicit and implicit tax structure --
taking
into account the variables that others have cited. I think that
the choice of any one variable, such as marginal tax rates,
is
terrible policy.

Where this leads is that you need cooperation between AID,

the Fund, the Bank, and other donors in Africa. But I think
that
trade policy is really the critical issue in many of these
countries. You see their protection is given to the wrong
industries and that they have exchange rate problems. I think a
lot more attention should be paid to this issue.

Ved Ghandi, International Monetary Fund:

I agree with the authors' conclusion that many developing

countries have not adopted sound economic policies. Our own
studies have also revealed that in developing countries depressed
farm prices have curbed agricultural production and exports,
regulated interest rates have discouraged savings, and overvalued
exchange rates have distorted production structures. Therefore,
governments of developing countries need to reform their
nontax
economic policies in the interest of generating savings and
growth.
This will not, in itself, be enough. As the development
literature has stressed, generation of savings is a necessary
but
not a sufficient condition for economic growth to take place.
Certain complementary factors would be required if savings
are to
become investment, and these would include the removal of
domestic constraints (viz., foreign exchange availability)
as well
as the removal of domestic constraints (viz., expanding the
size
of the market, developing necessary social and economic
infrastructure, facilitating the transfer of technology, and

169
 establishing adequate capital market and financial intermediary
institutions).

The development literature has also established that growth

by itself would not mean development unless accompanied by certain
instituional reforms, such as humnan capital formation, land
reform, and population control. Therefore, one must conclude that
reforms in economic policies are certainly desirable but i'i no
case should they be considered a sufficient condition for rapid
economic development.

Rartlett and Rabushka also conclude that the supply-side

approach can be applicable to developing countries, but it appears
that more empirical evidence would be needed to be convincing.
The Fund has begun to give serious thought to an assessment of
its
relevance, and in doing so, we have raised four fundamental
questions:

-- Are labor supply, savings, aad investment price sensitive

in developing countries?

-- Do tax policies (tax rates and incentives) in developing

countries significantly affect savings behavior, especially
the availability of financial savings?

-- Do tax policies in developing countries significantly

affect investment behavior?

Do high and progressive income tax rates significantly

,ffect income tax evasion in developing countries?
Kn.t research has identified the following:

-- The literature examining the price responsiveness of labor

supply, savings, and investment in developing countries
leaves much to be desired, but it nonetheless appears that
changes in tax policy will have some effect. However, the
behavior of these aggregates is also determined at least as
much by other economic and noneconomic elements as by prices.

-- The optimal tax treatment of financial savings seems to

depend critically on the degree of financial repression,
which varies widely both across countries and over time. Our
conclusion is that there is no single recommended policy
action, such as reducing the marginal income tax rate.

-- Relating the share of gross domestic investment in gross

domestic product to the cost of capital estimates for more
than thirty developing countries, we find that while the cost
of capital has a significant impact on investment levels,
other variables, especially the rate of inflation and the
growth of exports, are eq:,ally important. Our conclusion,
therefore, is that strong policy conclusions concerning the
effectiveness of tax rate reductions alone in encouraging
 investment in developing
countries should be resisted.
Attention should be paid
to controlling inflation
alleviating distortions and
to exports resulting from
rate and producer pricing exchange
policies.
-- The theoretical literature
that an increase in the does not support the claims
tax rate will lead to an
tax evasion, or that a progressive increase in
evasion. One finds that tax schedule stimulates
tax
the literature contains
conclusions regarding the stronger
role of other tax and non-tax
factors in affecting evasion.
rates and high probability In particular high penalty
of detection are shown
negative effect on tax evasion. to have a
Income tax evasion is also
shown to be strongly influenced
the type of income and perception by non-tax factors such
as
one ends up doubting the of fiscal equity. Thus,
effect which a reduction
rates or even reform in of tax
tax policies alone will
degree of income tax evasion have on the
in developing countries.
The conclusion of our research
tax policy prescription is that while the supply-side
of reducing marginal income
not invalid, there are many tax rates is
determinants of the behavior other important tax and non-tax
of economic agents in developing
countries and constraints
on their economic development
marginal income tax rates. than high
Tax policy reforms in developing
countries has to be based
on a mix of supply-side
as well as other
relevant considerations.

Gustav Papanek, Boston University:

There is good empirical and

of the important points in theoretical support for several
the Rabushka-Bartiett paper.
central point, as I see it, Their
is that most economic interventions
governments of LDCs are distorting, by
economic efficiency, and therefore moving the economy away from
substantial evidence, from a slowing growth. There is
supported by AID, that this study of five Asian countries
is a valid observation. Two
arguments are also both logical specific
and well supported:
-- high rates of taxation
on agricultural commodities
discourage their production;
and
-- high rates of personal
income tax, if enforced, encourage
capital flight, tax evasion
and avoidance, discourage
taking, and may discourage risk­
effort.
However, there is no very
marginal rates and low thresholdspersuasive evidence that high
significant factor in slowing of income tax have been a
growth. On the total tax very
evidence given shows the reverse rate, the
higher taxes are associated. relationship: higher growth
and
plausible: that more rapidly The explanation offered is
willing to extract more taxes.growing countries are able
and
But that relationship should
give

171
 RIP

t fo seerI'easo':

teator C pausei~onot demons~thtrat caua't, th u

presen sosaegv'causal us reainshi
on toeothee
wincome~~~~tax~~ra-com
antro t ,afxese a ~esns >
nina

<, Cor
Sttitialsupot 6r
cthioe~s, haveial tax busrdetin.; d2 l2 Oth e'
11 i, h autor
siecoe ian
d e-n o m if6 o~Utsatt rms fl axi toagroth
nromue
C9Ule4payr
ei;d incme xst
role 2

: h or e h-i~
avL~n
Iae
fe b s rvatin us dollar
thd nominjjon: ofta
use i
In_
ort.aii i a bias (anals
st­
thresh
inold tx, .an 'rwts th
ises taf ta&mitand
'2
2
that~ <ai ngtx ie2
haetohigrict andy
a,v aying growth, r'ates are rael
notn sub:tthe:efiafl
c'6 i 1 e2 t'$ .
2-at's­
i-ji
Th-iaThisefev taxoragetet tiscetaily moe ipra~ttan'
the~~~
rae sd
nominalcs
n>I: nayis
~short,
j In i an relationi
ss1kl
thaeeat~
2I~r~rltiof~
ihmtlof ta
nominl2 eresum4 f
r pliies2
'adot is tie 2
ratsf/the'o-4 rate
the a-h
$ taeea e -~ hv't
ef'Tht ,on s nrot, a' nottolida ot e 2,wo1 k'

e-cro rt bu~liitas taesae

cs, e,. 2 ffec'P&f
-
rrelllected viat esuh hig
2'

'r"­
2 2

e-22u ia
24 su plnsd n u p y o
-n d qpa e f LD t . cIa rus e d ear'igh ersthal oneo ' 'mpe ,x ,- ,! u
2 a" -' ,2 ' 2 t 6-­

inadequatle sa ingsme r~ ates

n' iceniecnrls
eutie
compet' i ti r e p.tesI u're s -alsotiv

dihe~Th
M" a' n2 rate
toes ti ar lo
n ot e '< i

-A
,222
re of theeger,
C2-C 222222
A>t-
.2, sg es
--
s th tma releva
y co
-A~ pn v
ent rables,are
12 the 2of
21 '1 ­ ", 2' 2 72,. 2
22

-p222v e si oefice ncy b c

fi' e a e ibjarent'-ap i ol soc and
2
2, the. most euent
v an~i- 'n22"22, t h~ erta ll o yt c ap~ tao s o ''o po e t
n22 d2222- t n -c n m ec . 2'2Xa
' r d c i ' Ac 2bv
2~ ,, u h erentmpe titjse-qrossurdsai
c'oe' n'2in
2 2
e r le nopojha
an e lbt ter 'a reio cearlyp i ore imolls rtaint an A2$ 2'
det~~~rmi~t
~2'4 ~ Ap2ong
2222u
22, '~2
en' , J2,.
2$2
pr
22,2
aucss
22
I,2
222412A~~
2~2 2'
the 2 12
exercise2 ' $ .
 considerable caution in doing cross-country experiments
with
single-policy variables -- or even multi-variate regressions
--
because of the complexity -f the phenomemnon of growth.
One needs
to get richness and texture, and this requires country
specific
analysis.

As for policy, I would like to lay out several commandments

that I think merit our consideration, and which reflect
the
complexity of the policy-making process:
-- Avoid false technicism in economic policy making. Do not
allow prohjections to become plans;

-- Keep budgets under adequate control;

-- Keep inflationary presssures under reasonable control;

-- Take advantage of international trade; comparative

advantage is one of God's greatest inventions;

-- Avoid excessive income tax breaks;

-- Avoid excessive use of tax incentives to achieve

particular objectives;

-- Use price and wage controls, quotas, licenses and

similar
restrictions sparingly, if at all;

-- Allow public sector enterprises to behave like

private
sector enterprises; and

-- Finally, make the borderline between public sector

and
private sector activity clear and well-defined.

These commandments form a sensible basis for think

ing about
a research agenda for future work in this field

173