Political Economy of Taxation in Africa: Fiscal Legitimacy and Public Expenditure

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1 Political Economy of Taxation in Africa: Fiscal Legitimacy and Public Expenditure Introduction The issue addressed in this paper is the link between the political credibility or legitimacy of the state and the voluntary compliance by taxpayers in meeting their tax liabilities. Specifically it asks whether raising the quality of public expenditures, so that taxpayers receive better services from the state, will strengthen the legitimacy of the state and thereby encourage voluntary compliance. Underlying this issue is a notion of an implicit contract between the state and citizens in which the latter voluntarily pay taxes in return for public services from the state, with the specifics of this relationship (e.g. the tax burden on different sections of society and the public services that they receive) mediated through the political process. States with a broad tax base are more likely to provide accountable and representative government, and will also have strong incentives to promote the prosperity of taxpayers (Moore 2007). Background Domestic revenue mobilisation in sub-saharan Africa (SSA) is generally weak in comparison to other parts of the world. Excluding revenues from natural resources such as oil, which are cyclical, tax revenues in SSA averaged about 14 percent of GDP in 2005, only slightly higher than the 13 percent of GDP in 1980 (Keen and Mansour, 2009). The low levels of revenue mobilisation in SSA are attributed to the structure of the economy, with a very narrow tax base, especially for income taxes, a large share of difficult to tax informal activities in GDP, and weaknesses in tax administration. States in SSA facing a fiscal crisis have often been able to implement tax reforms to boost revenue from very low levels (especially after economic collapse), but sustaining growth of the revenue to GDP ratio over a long period has proved much more difficult. 1

2 How does the political economy affect tax mobilisation? The political economy of the countries of SSA is complex and heterogeneous, but to a greater or lesser extent, the distribution of patronage by political elites using public resources is integral to the political process in most countries. Arguably, the introduction of competitive electoral politics has raised the requirements for resources to fund patronage substantially. The liberalisation of African economies in the last two or three decades, closed off many of the avenues for raising resources for patronage which had previously been important, such as the control of underpriced foreign exchange, import licenses, export commodity marketing boards and state owned enterprises. This consolidation of the public sector around a narrower set of activities has meant that government budgets have become more important as a source of funds for patronage, especially in countries where budget envelopes have expanded due to increased aid or natural resource rents. Resources for patronage can be obtained from both sides of the budget; from public expenditures or revenues. Governance related weaknesses in tax administration tend to reflect governance related weaknesses throughout the public financial management system. The most important channels through which resources for patronage are obtained from the tax system are twofold. First, tax concessions, such as income tax holidays or import duty exemptions, are granted to politically favoured companies on a selective basis, in circumstances where there is no strong objective rationale for granting tax incentives. Although this is often not illegal, it is usually done in a very untransparent manner. In many countries, large taxpayers, such as major companies, are more likely to bargain directly with government for tax concessions which favour them individually, rather than for groups of taxpayers representing common interests (e.g. the business sector) to bargain for changes in taxes which would benefit themselves collectively, and which would be transparent. 2

3 Secondly, taxpayers connive with corrupt tax officials to reduce their tax liabilities, as for example when importers evade paying the correct amount of customs duty. Tax policy reforms to boost revenue mobilisation often prioritise broadening the tax base, because imposing moderate tax rates on a broad base of taxpayers is usually less costly in terms of distortions to resource allocations than raising tax rates applied to the existing narrow base of tax payers. Broadening the tax base will usually involve reducing tax exemptions and bringing unrecorded income, such as urban rental income, into the tax net, but the scope for doing this is constrained by the political economy factors discussed above. The former would provoke political opposition from the taxpayers who benefit from exemptions while the latter would be very difficult to enforce, because of the scope for evasion in connivance with corrupt tax officials. Is there a link between voluntary compliance by taxpayers and the quality of public services? The argument that improving the quality of public services in SSA will boost the credibility of the state and thereby encourage greater voluntary compliance by taxpayers appears to be rather tenuous. First, the paying of taxes involves a private cost to the taxpayer, whereas public services are a social benefit. For any individual taxpayer, the private gains in terms of better services would be insignificant in comparison to the cost in terms of paying more taxes. As noted above, much of the bargaining that does take place over tax policy in SSA, between taxpayers and government officials, involves individual taxpayers rather than organised groups of taxpayers with a common interest who might be prepared to trade off a higher tax burden for better services. Moreover, the most important tax evaders in Africa have much less need of public services than the average citizen, as they are rich enough to afford private services. Taxpayer compliance is weak in Africa, not because taxpayers are disillusioned with the state, but because the probability of 3

4 detection is low and the penalties if detected are not a serious deterrent. Compliance is high for taxes such as personal income tax on formal sector employment because the scope for evasion is very small, but these taxes usually comprise less than 20 percent of total taxes in SSA. Taxpayers comply voluntarily in developed economies because they operate in an economy where detection of non compliance is much more likely and where the penalties for tax evasion are often severe. Secondly, the quality of public services is only one factor among many which affect the legitimacy of the state in the eyes of its citizens. Other factors which appear to influence the legitimacy of governments are: the role that the governing party played in liberation struggles, the restoration of security after civil conflict, the record of economic growth and a fair ethnic distribution of resources. Institutional Reforms to Tax Administration Efforts to improve governance in public financial management have focussed on institutional reforms, which in tax administration have often taken the form of establishing autonomous revenue authorities (ARAs) to replace tax administration structures within the civil service. The rationale for ARAs is influenced by theories of new public finance, in which it is argued that some of the governance problems of the public sector, including political interference in public administration and weak incentives for efficiency facing public employees can be tackled by setting up agencies which have managerial autonomy from politicians, with a clear mandate to deliver a specific service, performance targets and salary levels high enough to be competitive with the private sector. ARAs have been set up in 14 SSA countries, with the support of international organisations and donors (Fjeldstad and Moore, 2009). Although ARAs can make it easier to implement reforms which improve the efficiency of tax administration, such as large taxpayer units, it is not clear that they have radically improved the governance of tax administration. Informal relationships play an important role in public 4

5 administration in SSA and sometimes override formal lines of authority. The management of ARAs has not been insulated from political interference, in the hiring of staff and the treatment of taxpayers. References Bird, Richard M. (2008) Tax Challenges facing Developing Countries, Working paper no 12, Institute for International Business, University of Toronto. Di John, Jonathan (2006), The Political Economy of Taxation and Tax Reform in Developing Countries, Research Paper No. 2006/74, UNU-WIDER. Fjeldstad, Odd-Helge and Mick Moore (2009), Revenue authorities and public authority in sub- Saharan Africa Journal of Modern African Studies, 47, 1, pp1-18. Keen, Michael and Mario Mansour (2009), Revenue Mobilisation in Sub-Saharan Africa: Challenges from Gloabilization, Working Paper WP/09/157, International Monetary Fund Moore, Mick (2007) How Does Taxation Affect the Quality of Governance Working Ppaer 280, Institute of Development Studies. 5