The Financial Express

Adequacy of fiscal policy - a critical challenge

| Updated: October 23, 2017 07:56:28

Adequacy of fiscal policy - a critical challenge

Bangladesh has made tremendous development progress over the past several years and now aspires to reach upper middle-income status by the World Bank's income grouping criteria by fiscal year (FY) 2030-31. It also aspires to eliminate extreme poverty by the same deadline.  Bangladesh faces many challenges in achieving these laudable aspirations, including large increases in public and private investment rates;  huge increases in social spending including on health, education and social protection; and substantial improvements in governance and institutions.  These challenges are well-known and also embedded in several recent government strategy documents including the seventh Five Year Plan. 
A critical policy challenge in this regard is the adequacy of fiscal policy.  While there is no conclusive evidence in the economics literature regarding the optimal size of a government and the associated levels of taxation and public spending, the inadequacy of fiscal policy for securing the government's development objectives can be illustrated by the facts that the tax revenue as a share of gross domestic product (GDP) is amongst the lowest in the world, and social spending as a share of GDP is low by international standards and grossly inadequate relative to development needs. 
Nobody in the government debates these concerns.  Indeed, the 7th Plan is remarkably frank and explicit about these policy challenges.  The government adopted a Tax Modernization Plan in 2011. Every year, the national budget sets ambitious revenue targets to strengthen the government's revenue mobilization as per the Tax Modernization Plan. The outcomes, however, are much less than satisfactory. A major constraint is that the tax policy is not grounded in securing major shifts in the tax structure that not only will increase the tax/ GDP ratio but also allow a modernization of the tax structure that is consistent with the multiple objectives of sustained increases in tax revenues, preserving tax equity considerations and imposing minimum loses to efficiency and investment incentives.
The government is now preparing for the next national budget for FY2017-18. This will be the third budget under the 7th Five Year Plan. Can the government break from the past and adopt a tax policy that will enable some radical shifts in the tax structure over the medium term?  The objective of this write-up is to provide some inputs to this debate.  Its contention is that despite past progress, the Bangladesh tax structure resembles that of a low-income economy and has not graduated to the tax structure of even a low middle-income country, even though it achieved that status in FY2014-15.  The policy reforms that are needed have been debated and discussed but not implemented. 
The recent trend of tax/GDP ratio is shown in Figure 1.  The structure of taxation is illustrated in Figure 2. The Figures show that over the past seven years (FY2009-FY2016) the tax improvement effort has made only modest progress. Total tax collection as a share of GDP increased during FY2009 and FY2012, but has remained basically stagnant since then at around 9.0 per cent of GDP.  For all the years since FY2012, the tax target has been missed. The structure of taxation has improved modestly. There has been some improvement in the role of income taxation and domestic production/consumption taxation while the reliance on international trade taxation has declined. The increased role of domestic production/consumption taxation reflects the growing importance of the value-added tax (VAT) in revenue generation.  This is a positive development; yet the productivity of the VAT has been stagnant since FY2011 (Figure 3).
A useful way of assessing the tax performance and the associated tax structure is to compare the Bangladesh experience with other countries. Using data from International Financial Statistics of the International Monetary Fund (IMF) for the years 1996-2001, Gordon and Lie summarize the results of the international tax structure by income groups as illustrated in Table 1. The income groups were selected from the World Bank classification of low income (below $745); lower middle income ($746-2975); upper middle income ($2979-9205); and upper income (greater than $9206) prevailing during 1996-2001. 
This is a very powerful table and tells a remarkably instructive story about the international experience with the modernization of the tax structure as income grows and development proceeds.  The main messages are:
First, the tax/GDP ratio tends to increase with income growth.  The main policy implication is that the structure of taxation should be such that it responds well to income growth.  In other words, the tax structure must be buoyant with respect to the expansion of economic activities as reflected by the level of GDP. 
Second, as development proceeds, the share of income taxes grows.  Indeed developed countries raise more than 50 per cent of their revenues from income taxes. The rationale for this based on the need to have a tax structure that meets three desirable principles of taxation: the ability to pay; equity principles of taxation; and the buoyancy argument.  
Third, developed and upper middle income countries rely much more on personal income taxes relative to corporate taxes.  Thus, developed countries obtain as much as 45 per cent of their total tax revenues from personal income taxes; corporate taxes account for less than 10 per cent of total tax collections.  The rationale here is that unduly high taxation of corporate sector would tend to reduce investment incentives and lead to capital flight, which would hurt growth. 
Fourth, as development proceeds, the role of international trade taxes tend to disappear.  Thus, it accounts for less than 1.0 per cent of total tax revenues for high income countries and around 5.0 per cent for upper middle-income countries.   Even lower middle-income countries get less than 10 per cent of their tax revenues from international trade taxes.  The rationale for this is the result that trade taxes tend to distort resource allocation, hurting exports and breeding inefficiency of domestic production.
Finally, reliance on consumption taxes, primarily the value-added tax (VAT), has gained universal acceptance as an important instrument for both developing and developed countries.  

The writer is vice-chairman of the Policy Research Institute of Bangladesh. 



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