The 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 the 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 the numerator and denominator of the tax–GDP ratio. For example, should the profits or 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 should be widely understood, and (c) it should be reliable. In view of these considerations, it is common practice to use GDP at market prices as the denominator of the tax–GDP ratio. GDP is preferred because it avoids the estimation of depreciation, which is subject to various statistical and conceptual problems. For example, the Organisation for Economic Co-operation and Development (OECD) uses GDP at market prices as the denominator for comparing tax–GDP ratios among its member countries.
The study of the 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 the tax–GDP ratio.
The tax–GDP ratio is generally regarded as an index of the 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 the tax–GDP ratio can be misleading because taxes, though a burden for individuals, are used to finance vital governmental activities and to make transfers to needy sections of society.
What then does the tax–GDP ratio signify? Since the tax–GDP ratio indicates the percentage of national income that is compulsorily transferred from private pockets to the public exchequer, and hence the relative share of government in the disposition of national income, it signifies the economic role of government in the national economy.
It is usually hypothesised that per capita income and the tax ratio move in the same direction, i.e., they are positively related
The ratio, however, does not reflect the importance of the 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 such as pensions and scholarships. If such transfer payments are deducted from total tax revenue, the ratio of the remaining tax revenue to GDP will show the importance of the government as a final purchaser of goods and services. Since revisions are not uncommon, particularly in developing countries, 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.
The tax–GDP ratio varies from country to country. What explains inter-country variations in tax ratios? The list of factors affecting the 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 the 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: The Stage of economic development is the first and foremost determinant of the tax ratio. Economic development is a multifaceted phenomenon affecting quality of life and, therefore, cannot be measured precisely by a single variable. Still, a variable frequently used as 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 hypothesised that per capita income and the 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 the income elasticity of demand for public goods is high at high levels of per capita income.
Moreover, since the development process is normally accompanied by increasing urbanisation, high literacy rates, 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 the 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.
Tax potential is greatly increased where industrial production dominates other sources of national income
Composition of GDP: Another determinant of the taxation level is the composition of GDP or the industrial origin of national output. Normally, a higher agricultural share in GDP is indicative of lower per capita income, and hence a low stage of economic 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. The preponderance of the agricultural sector means lack of industrialisation, the existence of a large subsistence sector, and administrative difficulties in implementing tax laws. Moreover, there is effective political resistance to taxation of the agricultural sector. All these factors explain the negative influence of the agricultural sector on tax ratios.
Conversely, the relative share of the mining sector has a positive influence on the 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. Industrialisation is associated with urbanisation, banking transactions, and accounting practices, all of which facilitate the levy and collection of taxes. Some taxes (e.g., corporation tax) are directly linked with industrial activities.
Foreign Trade: Another determinant of the 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 than internal transactions. Moreover, a relatively large external sector is indicative of a greater degree of monetisation and an organised industrial sector, both of which are favourable conditions for taxation.
There are three alternative measures of the size of the foreign trade sector based on combinations of import and/or export share of GNP. These are: (a) the import ratio (My), (b) the export ratio (Xy), and (c) the openness ratio, i.e., the ratio of imports plus exports (My + Xy) to GNP. Theoretically, the use of the openness ratio is justified 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, the size distribution of income becomes another determinant of the tax ratio. It is widely believed that the scope for taxation is greater when the 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 Pakistan, the near absence of personal and corporate agricultural income tax is mainly due to the preponderance of absentee landowners and other vested interests in state legislatures.
Among the qualitative factors, the important ones are the efficiency of tax administration, the attitude of the citizens towards government and its laws, and the 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 in the third part.