Personal Income Tax Has Untapped Potentials In Poorer Countries-Research

Many governments aiming to achieve a durable economic recovery from the pandemic must raise significant amounts of revenue in the fairest way possible. The Personal Income Tax—levied on wages, salaries, and other income—is a suitable instrument for this challenge. In new research, experts examine the scope for making greater use of this fiscal tool in developing countries, where many people earn a living at low incomes.

The personal income tax had become the predominant tax by the eve of World War II in many advanced economies, where it now raises approximately 9 per cent of gross domestic product. In addition to bringing in revenue, it is progressive—imposing steeper rates on those with a higher income—and reduces inequality measurably.

In most emerging markets and low-income countries, on the other hand, such taxes are still in their infancy. Revenue from this source averages only 2.5 per cent of GDP in these countries, in part because of their narrow tax base, and it does little to lessen inequality.

But gradual changes have been taking place. In the two decades preceding the pandemic, income tax revenue more than doubled in low-income countries, rising from the equivalent of one per cent of GDP to 2.1 per cent, while emerging markets saw an increase from 2.1 per cent to 3.1 per cent. These were also reflected in the share of the tax in overall tax intake, which went from 5 per cent to 8 per cent of total tax revenue in low-income countries and from 9 per cent to 11 per cent in emerging markets.

Experts’ positions hold important lessons for developing countries, particularly as they grapple with the post-pandemic challenge of building the capacity to raise more tax revenue.

In examining the progress of the personal income tax in developing countries, analysts distinguish between observable tax policy changes and broader economic changes. Policy changes have targeted top and bottom statutory rates as well as the level of exempt income. Remarkably, these analysts find that this hasn’t contributed much to the increase in revenue in low-income countries.

And in emerging market economies, this shift has sometimes actually reduced revenue. This is the case in part because many emerging markets have introduced flat tax systems with low rates and those with progressive schedules have reduced rates over the last two decades.

Economic variables, on the other hand, played a very important role. Experts looked at increases in per capita incomes and the size of the public-sector wage bill and the reduction in the size of the informal sector, as measured by the share of self-employed workers in the labour force and the share of agriculture in the economy. These developments have clearly been the driving force behind the growth in personal income tax revenues. As economies develop, it is expected this tax to take on greater importance.

Improvements in tax administration also potentially play a role in boosting revenues, though that also extends to other taxes. Moreover, the accelerated shift into digitalized services because of the pandemic can pave the way for better income tax design and enforcement.