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Major changes in taxation vs. Major changes in politics

taxation

Major changes in taxation generally require major change either in the political reality of a country or in its economic circumstances. In normal times a good tax reform one intended to raise more revenue in a more efficient and equitable fashion, for instance seems to be like a good seat belt law. That is, if everything else stays the same, lives would be saved (the tax ratio would increase).

However, things do not stay the same: some people drive faster when they are belted in, so death rates (tax ratios) show little change. Countries may tend to achieve an equilibrium position with respect to the size and nature of their fiscal systems reflecting largely the balance of political forces and institutions, then remain there until shocked into a new equilibrium. Two alternative explanations may lie behind this process. Either somewhat improbably supply (capacity) factors may change over time in such a way as to offset all attempts to raise tax ratios.

Or, more plausibly, ideas as to the proper tax level demand factors may change over time. Some evidence supports the latter position. For example, the two major explicit aims of tax policy in the period after the Second World War in most emerging countries around the world were, first, to raise revenue and lots of it in order to finance the state as the engine of development and, second, to redistribute income and wealth.

Then, as now, income and wealth were markedly unequally distributed in many developing countries, so the need for redressing the balance through the budget seemed obvious to most analysts (if not to those who might be adversely affected). The ability of taxes to do the job was largely unquestioned. Indeed, both revenue and redistribution could, it was generally thought, be achieved best by imposing high effective tax rates on income, essentially because the depressing effects of taxes on investment and saving were considered to be small.

Indeed, an extra bonus of high rates was sometimes argued to be that they made it easier to lead balky private investors by the very visible hand of well-designed fiscal incentives into those channels most needed for developmental purposes. The conventional wisdom at the time was essentially that all developing countries needed to do to solve their fiscal problems was to learn to tax and to most that meant to tax in a properly progressive fashion. Views on the appropriate role and structure of taxation began to change in the 1970s and 1980s, however.

By 1990, most economists and policymakers believed that high tax rates (especially on income) not only discouraged and distorted economic activity but were largely ineffective in redistributing income and wealth. Reflecting this new view, income tax rates on both persons and corporations were cut sharply and are now almost universally in the 9% to 20% range in Balkans, as elsewhere in the countries not completely developed in the world. On the other hand, reflecting indeed, to some extent leading worldwide trends, VAT is now the mainstay of the revenue system in the region, as in the world more generally.

Other factors have been at play also. For example, taxes on international trade have declined with trade liberalization and the WTO. Together with increased competition for foreign investment, the result has been to move international concerns from the bottom to the top of the tax policy action list. At the same time, in many countries a new issue has risen to prominence on the fiscal menu as decentralization made the question of setting up adequate subnational tax systems an increasing concern.

The tax policy world is thus very different in many respects at the second decade of this century than it was in the middle of the last century. Ideas matter.

Ideas about tax policy have clearly changed over time. Have institutions and interests also changed?

Forty years ago, best analyzed Central American tax policy in a class framework. He argued that in principle changes in tax level structure (e.g., the degree of emphasis on income taxation) essentially reflected the changing political balance of power among landlords, capitalists, workers, and peasants. Shortly after his article appeared, an explicitly Leftist regime (the Sandinistas) took over in Nicaragua.

What happened to taxes?

Three things:

Firstly, as Best (1976) would have predicted, the tax ratio rose very quickly, from 18% to 32% of GDP within the first five years of the Sandinista regime.

Secondly, however, almost all the increase in tax revenue was derived from (probably) regressive indirect taxes and not from the (at least nominally) progressive income taxes.

Thirdly, and in many ways most interestingly, once Nicaragua’s tax ratio was increased, it stayed up there even a decade (and three subsequent governments) after the defeat of the Sandinistas. As this example suggests, political ideas definitely matter in taxation, but they do not necessarily dominate. Economic and administrative realities also matter. 

The fiscal reality found at any point of time in any country reflects a changing mixture of ideas, interests, and institutions. Few real-world tax structures have been designed with any particular objective in mind. On the contrary, they often seem like Topsy to have just growed in ways shaped by both the changing local environment and the changing external context.

The ideas on the relevant balance between taxes and society that were forged over the first half of the 20th century seem too many to have changed, as evidenced by the death of death taxes in developed countries and the very limited success of developing countries in achieving the high levels of income taxation to which many of them aspired in the postcolonial period. So far, however, reality in terms of both tax levels and the distribution of tax burdens seems to have changed rather less than ideas about what it should be.