Tax Policy Challenges Facing Developing Countries

Tax Policy Challenges Facing Developing Countries
Developing countries attempting to become fully integrated in the world economy will probably need a higher tax level if they are to pursue a government role closer to that of industrial countries, which, on average, enjoy twice the tax revenue. Developing countries will need to reduce sharply their reliance on foreign trade taxes, without at the same time creating economic disincentives, especially in raising more revenue from personal income tax. To meet these challenges, policymakers in these countries will have to get their policy priorities right and have the political will to implement the necessary reforms. Tax administrations must be strengthened to accompany the needed policy changes.
As trade barriers come down and capital becomes more mobile, the formulation of sound tax policy poses significant challenges for developing countries. The need to replace foreign trade taxes with domestic taxes will be accompanied by growing concerns about profit diversion by foreign investors, which weak provisions against tax abuse in the tax laws as well as inadequate technical training of tax auditors in many developing countries are currently unable to deter. A concerted effort to eliminate these deficiencies is therefore of the utmost urgency.
Tax competition is another policy challenge in a world of liberalized capital movement. The effectiveness of tax incentives—in the absence of other necessary fundamentals—is highly questionable. A tax system that is riddled with such incentives will inevitably provide fertile grounds for rent-seeking activities. To allow their emerging markets to take proper root, developing countries would be well advised to refrain from reliance on poorly targeted tax incentives as the main vehicle for investment promotion.
Finally, personal income taxes have been contributing very little to total tax revenue in many developing countries. Apart from structural, policy, and administrative considerations, the ease with which income received by individuals can be invested abroad significantly contributes to this outcome. Taxing this income is therefore a daunting challenge for developing countries. This has been particularly problematic in several Latin American countries that have largely stopped taxing financial income to encourage financial capital to remain in the country.

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