Tax revenues in low-income countries

What is this research about and why did you do it?

Our paper studies the costs of increasing tax revenues in low-income countries. It looks at both, the efficiency and distributional costs associated with raising revenues through different tax instruments –consumption, labor income, and capital income taxes. The study is rooted in the context of low-income countries' unique economic structures, where issues like rural-urban disparities and limited labor mobility play a significant role in shaping the effects of tax policies.

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How did you answer this question?

The study employs a dynamic general equilibrium model with heterogeneous agents, segmented labor markets, and regional differences. This model is calibrated to Ethiopia's economy. capturing its specific economic characteristics, such as the rural-urban divide and income distribution. The model is used to simulate the effects of increasing tax-to-GDP ratios using different tax instruments.

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What did you find?

VAT and Economic Output: The study illustrates that increasing VAT is the least disruptive to overall economic output but has the most profound impact on distribution. A 2% VAT increase results in a 2.3%output decline. This comparatively smaller impact on output, as opposed to CIT and PIT, arises from the broader tax base of VAT. However, it disproportionately affects the lower-income groups, primarily in rural areas, due to their higher reliance on VAT-affected goods and services.

Changes in Macro Aggregates and Gini coefficients

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Different Impacts Across Tax Types: The analysis shows VAT increases lead to a substantial 4.37% loss in consumption equivalent changes, significantly higher than CIT (1.25%) and PIT (1.7%). This greater loss stems from VAT's regressive nature, affecting a wider population segment and reducing overall consumption more severely, particularly among lower-income households.

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Regional Disparities from Tax Changes: The research highlights the significant shift in tax burdens across regions following tax reforms. The rural areas are hit hardest, evident from the changes in aggregate food demand and spending patterns post-tax alterations. This shift is driven by the rural population's higher dependence on goods heavily taxed under VAT, exacerbating existing economic disparities between rural and urban areas.

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Understanding the Impact of VAT on Rural Areas

Relative Price Distortion: The imposition of VAT causes a distortion in relative prices, favouring urban goods. This shift in demand towards informal urban goods disproportionately affects rural households, who consume a narrower range of goods, many subject to VAT.

‍Regressive Nature of VAT: Unlike CIT and PIT, which target formal urban sectors and wealthier taxpayers, VAT lacks progressiveness. The regressive nature of VAT imposes a heavier tax burden on rural populations, characterized by lower average incomes and less diverse income sources.

‍Government Spending Patterns: The government often reallocates increased tax revenue towards urban sector goods. This urban-centric spending pattern further exacerbates welfare costs in rural areas, as these populations do not benefit equally from such government expenditures.

‍Between-Region Redistribution Issues: The study emphasizes the importance of distinguishing between within- and between-region redistribution. VAT increases lead to significant disparities between regions, disproportionately affecting rural areas due to their unique economic structure and consumption patterns.

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Policy Interventions to Counter Negative Taxation Effects

The paper discusses a specific policy intervention to alleviate the welfare costs associated with VAT increases, particularly for the rural population. It suggests that lump-sum transfers, amounting to three-quarters of the additional revenues generated from VAT, can effectively nullify the welfare costs associated with the VAT increase. This policy recommendation is significant as it offers a direct way to counterbalance the disproportionate tax burden on the rural population, addressing the issue of equity while maintaining the efficiency benefits of VAT.

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What implications does this have for the study (research and teaching) of wealth concentration or economic inequality?

The findings suggest a complex interplay between tax policy efficiency and equity in low-income economies. While VAT appears less disruptive to overall output, its regressive nature disproportionately burdens lower-income, particularly rural, populations. This underscores the need for carefully balanced tax strategies that account for both revenue generation and distributional fairness.

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What are the next steps in your agenda?

Future research should delve into the long-term impacts of these tax policies on economic growth and inequality. A key focus will be exploring more equitable tax structures and assessing the effectiveness of different tax instruments in diverse economic contexts of low-income countries. Comparative studies across low-income countries can provide broader insights into effective taxation strategies.

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Citation

Peralta-Alva, A., Tam, X. S., Tang, X., & Tavares,M. M. (2023). "Tax Revenues in Low-Income Countries". The Economic Journal, 133(653), pp2001–2024.