Dr. Ikramul Haq
Level of taxation in a country is traditionally judged in terms of the ratio, which taxes bear to some measure of national income. This ratio is called tax-GDP ratio and the change in it is determined by variations in both the numerator (total tax revenue) and the denominator (national income).
There are various problems associated with the definitions of numerator and denominator of tax-GDP ratio. For example, should profits/losses of public monopolies form part of the numerator? Should social security contributions be included in tax receipts? The denominator of the ratio suffers from more ambiguities because there are various measures of national income. Among the alternative measures of national income, the important ones are: Gross Domestic Product (GDP), Gross National Product (GNP), and Net National Product (NNP). Should taxes be related to GDP or GNP or NNP, and whether at market prices or at factor cost?
In choosing from the alternative measures of national income, the important considerations are: (a) the measure chosen should be readily available, (b) it is widely understood, and (c) it is reliable. In view of these considerations, it is a common practice to use GDP at market prices as the denominator of the tax-GDP ratio. GDP is preferred because it avoids estimation of depreciation that is subject to various statistical conceptual problems. For example, the Organisation for Economic Co-operation and Development uses GDP at market prices as the denominator for comparing tax-GDP ratios among its member countries.
The study of tax-GDP ratio is important because trends in taxation in a country or group of countries are analysed mainly in terms of this ratio, and the composition of tax revenues. The latter may change owing to variations in tax-GDP ratio.
Tax-GDP ratio is generally regarded as an index of relative tax burden in a country over a period of time or when countries are compared for the same period (cross-section analysis). To describe tax burden in terms of tax-GDP ratio can be misleading because tax, though burden for individuals, are used to finance vital governmental activities and to make transfers to needy sections of society.
What then does tax-GDP ratio signify? Since tax-GDP ratio indicates the percentage of national income that is compulsorily transferred from private pockets to public exchequer, and hence the relative share of government in the disposition of national income, it signifies the economic role of a government in the national economy.
The ratio, however, does not reflect the importance of government sector as a final purchaser of goods and services because a part of tax revenue is returned to the private sector in the form of transfer payments like pensions and scholarships. If such transfer payments are deducted from the total tax revenue, the ratio of the remaining tax revenue to GDP will show importance of government as a final purchaser of goods and services. Since revisions are not uncommon, particularly in developing countries, and therefore they indicate a limitation of the use of tax-GDP ratios. These cautions must be kept in mind while interpreting tax-GDP ratios.
Since an adequate volume of government revenue is essential for public expenditure and economic growth, the ratio of tax revenue to GDP has been used regularly to measure and judge the success of a country’s fiscal management.
Tax-GDP ratio varies from country to country. What explains inter-country variations in tax ratios? The list of factors affecting tax ratio is almost inexhaustible. It includes a wide variety of economic, social, cultural, and political factors. Broadly speaking, the variables explaining inter-country variations in tax ratio may be grouped under two categories:
- Quantitative or statistical factors, and
- Qualitative or institutional factors.
Among the quantitative factors the important ones are the following. These factors are crucial as they determine the tax base which government uses to raise tax revenues. They are also the determinants of tax levels most widely used in empirical studies. They are believed to exert a strong influence over the tax ratio through their effect on what are called capacity factors.
- Stage of Development. Stage of economic development is the first and foremost determinant of tax ratio. Economic development is a multi-faceted phenomenon affecting quality of life and therefore cannot be measured precisely by single variable. Still, a variable frequently used a proxy is per capita income which, though incomplete, is by far the single best indicator of the stage of economic development attained by a country.
- It is usually hypothesized that per capita income and tax ratio move in the same direction, i.e. they are positively related. Presumably, people in countries with high per capita income require a smaller proportion of their incomes to meet their basic needs and hence are left with a surplus which may be conveniently taxed. It is also argued that income elasticity of demand for public goods is high at high levels of per capita income.
- Moreover, since development process is normally accompanied by increasing urbanisaiton, high literacy rate, widespread monetisation, public consciousness, and improved administration, the scope of taxation, particularly direct taxation, increases because all these factors are conducive to tax collection. However, in the context of inter-country comparisons, the use of per capita income as a determinant of tax ratio is subject to errors owing to the conversion of domestic currencies into US dollars. Moreover, the relationship between tax ratio and per capita income becomes decisive only after the latter has reached a minimum level, though it is difficult to define that level.
Composition of GDP. Another determinant of taxation level is the composition of GDP or the industrial origin of national output. Normally, a higher agricultural share in GDP is indicative of a lower per capita income, and hence a low stage of economic development. Thus, the proportion of income generated in the agricultural sector provides another index of a stage of development. Two countries may have the same level of per capita income but differences in the composition of their national output will affect their taxable capacities and tax ratios. Preponderance of agricultural sector means lack of industrialisaiton, existence of a large subsistence sector and administrative difficulties in implementing tax laws. Moreover, there is effective political resistance to taxation of agricultural sector. All these factors explain the negative influence of the agricultural sector on tax ration.
Contrarily, the relative share of mining sector has a positive influence on tax ratio. As Roy Bahl has opined, “the mining sector generally produces a larger surplus than any other sector, and therefore it is a positive determinant of taxable capacity. Because of the heavy fixed investment associated with mining industries, operations will tend to be confined to a few large firms, and accordingly it will be administratively easier to levy income or export taxes.”
Tax potential is greatly increased where industrial production dominates other sources of national income. Industrialisaiton is associated with urbanization, banking transaction, accounting practices, all of which facilitate levy and collection of taxes. Some taxes (e.g. corporation tax) are directly linked with industrial activities.
- Foreign Trade. Another determinant of tax level is the size of the foreign trade sector. It is presumed that taxable capacity increases with the expansion of external trade because it is administratively easier to tax trade inflows and outflows that internal transactions. Moreover, a relatively large size of external sector is indicative of greater degree of monetisation and organized industrial sector, both of which are favourable conditions for taxation.
- There are three alternative measures of the size of foreign trade sector based on combinations of import and/or export share of GNP. These are: (a) import ratio (My), (b) export ratio (Xy), and (c) openness ratio, i.e. the ratio of imports plus exports (my + xy) to GNP. Theoretically, the use of openness ratio justifies because it reflects the total trade base available for taxation.
Composition of Government Expenditure. If public expenditure pertains mainly to welfare activities (educational and medical services), it will favourably influence the general standard of living and hence the taxpaying capacity of the citizens. Conversely, if a large proportion of expenditure is devoted to defence, and law and order, the taxpaying capacity will be reduced.
Pattern of Income Distribution. Two countries with the same level of per capita income may have different taxable capacities if the pattern of income distribution differs. Thus, size distribution of income becomes another determinant of tax ratio. It is widely believed that scope for taxation is greater when degree of concentration of income and wealth is higher. This is not always true because economic concentration implies more political power with the rich who effectively resist additional tax burdens upon themselves. For example, in India the near absence of agricultural income tax is mainly due to the preponderance of landlords and other vested interests in state legislatures.
Among the qualitative factors, the important ones are: efficiency of tax administration, attitude of the citizens towards government and its laws, and ideology of the ruling party (e.g. left-wing governments prefer a larger public sector). It is difficult to quantify the influence of socio-political factors on taxable capacity. It will be discussed next week.
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Dr. Ikramul Haq, Advocate Supreme Court, Adjunct Faculty at Lahore University of Management Sciences (LUMS), member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE), holds LLD in tax laws. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He also served Civil Services of Pakistan from 1984 to 1996.