Tuesday, 24 March 2009

Tax Policy, at Last!

By Xavier Cirera

I am delighted to hear that the US House of Representatives is considering levying a 90% tax on bonuses paid to employees with incomes above $250,000. I even think that the proposal falls short; for those working in institutions being rescued with taxpayers’ money, the tax should be large enough to make the bonuses equal the amount they would be receiving if they were on unemployment benefits. But most important is that this news represents a very good opportunity to raise the forgotten issue of tax policy.

The current crisis has clearly exposed that incentives in the financial sector are largely distorted to obtain short run profits, jeopardising long run sustainability of financial institutions. The blame so far lies on risk models and lack of financial supervision. However, this omits a well known fact that one of the most important tools of governments for curbing incentives is taxes. Any standard economics textbook very clearly shows that when the social costs of an activity exceed the private costs of agents engaged in that activity, this should be taxed to equalise private and social costs (i.e. the pollution case). On the contrary, we have seen how, in the financial sector, incentives (bonuses) have been taxed mainly at capital gains tax rates, which are lower than the income tax that most households pay with much lower income levels. This is just an example of how taxation policy has been ignored for many years.

The omission of taxation from economic policy has not only affected financial sector incentives. Domestic taxation remains a serious constraint for developing countries’ growth, which tends to have a small income tax base. Efforts have been made to implement VAT schemes in many LDCs. Nevertheless, advances on direct taxation remain very modest. Many developing countries rely mainly on trade taxes and taxing a few firms in the formal sector, and some of these taxes can be quite distortive.

The positive link between tax and the quality of governance (pdf) is well documented (example by IDS colleague, Mick Moore). The question is then why tax policy has ranked so low in donor policy agendas. Even the IMF, in charge of policing fiscal deficits, has put far more emphasis on disciplining expenditure than on achieving a sound and diversified tax base. In addition, as Adrian Wood suggests , it is likely that aid flows have undermined any incentives for governments to prioritise the increase in tax revenue.

Whatever the reasons are for the marginalisation of tax policies from economic policy agendas, let’s hope that the current crisis pushes taxation back on the development agenda. Taxation is not only important for equity, but also for efficiency and growth.

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