The Wisdom of The Effective Tax System in 21st Century. Collecting More Without Raising the Bar

The Tricks of The Tax System: Raise Impossible Collect

In most developed countries tax revenue makes up a sizable portion of the government budget. The level of tax revenue collection directly depends on public opinion towards the taxation system, which depends on the tax culture in a particular country.

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Taxation is, by and large, the most important source of government revenue in nearly all countries. According to the most recent estimates from the International Centre for Tax and Development, total tax revenues account for more than 80% of total government revenue in about half of the countries in the world – and more than 50% in almost every country.

Our World in Data

Evolution of tax revenues, as a share of national income, for a selection of early-industrialized countries

Source: Our World in Data

The diagram, from Prichard et al. (2014), provides a conceptual classification of revenues other than debt. These revenues include grants, direct taxes (such as taxes on income, profits, property, etc.), indirect taxes (such as taxes on consumption, sales, trade, etc.), and social contributions.

The main instruments used by governments to collect revenue

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Government of any state is the provider of the public goods or services for its citizens, but cannot supply them for free. A comfortable level of public welfare requires solid financial resources besides implementing and maintaining various social, economic, medical, legal, and other systems. From this point of view, taxes represent the price citizens pay for the consumption of public goods and services based on the public agreement.

In many countries, society perceives taxes as the state’s attempt to extract private welfare without providing a valuable compensation. This interpretation is the primary motive for tax evasion and tax avoidance, which have a negative impact on government revenue collection. To establish an effective tax system, every government must start from increasing the financial literacy of the taxpayers and shaping a strong public tax culture. This will improve the public opinion towards the country’s tax system as the effective and valuable tool, which is essential to build a stronger public agreement between the state and its citizens.

Coming Out of the Shadows: a Pain or a Grace?

In any country with a large share of shadow economy, eventually companies and citizens can no longer avoid paying taxes and they must come out of the shadows. The pace at which taxpayers are “whitewashed” very much depends on the role that the state assumes to perform. Will it become a strict yet wise assistant, or a ruthless punisher?

Higher tax rates and strict tax administration and control do not provide the state’s economy with stability and effective tax revenue collection. Quite the opposite. The more the state “stifles” taxpayer, the more passionately and skillfully they try to hide and dodge the state efforts. Every business and person will use any loophole they can find to relieve their tax burden. The higher the taxes, the fewer of those willing to pay them in full. Taxpayers will never back the government in such an environment and will use all their resources and capabilities to resist and overthrow the government’s revenue collection efforts at every opportunity.

It is worth asking which is better: collecting from a small circle of the “doomed” and arousing their discontent and hostility, or collecting from the overwhelming majority while shifting the loyalty of the community over to the state cause? A wise government understands the more wealth the society earns, the better for the domestic economy. Therefore, the tactic of “skinning” those who did not know how to hide is not the best option.

High tax rates also may imply a negative effect for the economy and society as they lead to the growth of a shadow economy. That worsens the level of social security and satisfaction of the citizens. Informal wages entail scanty contributions to pension and health insurance funds, which inhibit the development of these social institutions. In addition, low tax collection causes enormous damage to the domestic economy, and the circulation of cash flows out of government control.

In these conditions, corruption grows rapidly at all levels, which has a negative effect on society and slows down the economic development of the state. As a result, federal and regional state budgets fall, and inflation rises. The level of trust in the government declines and investors rethink their plans to invest in large-scale and long-term projects.

Creating an Effective Tax System

It is extremely difficult to perform tax administration over the activities of organizations that are in the shadows, especially if the share of shadow businesses in the country’s economy is noticeably large. Governments should create the most comfortable environment for transitioning to legal methods of doing business with a comprehensive approach to reforming the tax administration system.

Effective taxation requires a reduction of the tax burden and simplification of the tax compliance processes for the taxpayers. The latter requires massive implementation of the modern digital tax administration solutions and transitioning to electronic document interchange and management. It is important to develop a set of measures to minimize a tax gap, strengthen control over financial transactions, exclude the possibility of fraud and laundering, limit the possibility of obtaining inappropriate loans, and introduce harsh penalties for officials who exceed their powers.

It is almost impossible to fight corruption at all levels in a complex state structure throughout the country. A pragmatic approach is to exclude the possibility of the influence of specific persons on the execution of any tax benefits. That may include taxable amounts calculation, reduction of the tax base, application of tax benefits and deductions, refunds from the budget, acceptance of VAT towards credits, etc. Implementation of an automated digital systems reduces the human factor, and the system can easily detect and act upon any attempts of the “manual” interference.

The government should also hedge an enforcement process by creating a favorable investment climate and reducing the tax burden. This will stop the outflow of funds from the country and create a situation in which it would be more profitable for a business to pay taxes rather than put the company at risk by investing efforts and funds in hiding income.

With the implementation of the modern digital tax administration solutions, the government of any country could achieve absolute transparency regarding the revenue collection processes and increase the level of trust and loyalty of the taxpayers and form a responsible tax culture

Examples of the Successful Reforms of the Tax Administration Systems

Tanzania has undertaken major tax policy reforms in the past decade to improve revenue collection. The principal goal was to increase revenues without raising tax rates. The government went through a digital transformation of the tax administration by integrating several types of financial transactions, introducing taxpayer segmentation and widespread implementation of information technology.

Implementing the new tax administration system involved:

• Introduction of the General Taxpayer Identification Numbers (TIN)
• Deployment of the new tax administration structure according to a single functional principle.
• Tax educational activities among the citizens and entrepreneurs conducted by a dedicated tax administration divisions assigned to the taxpayer groups by the territories.

The responsibility of the tax administration included explanatory work regarding regulatory compliance with the business registration requirements and providing quality assistance to small entrepreneurs in understanding and fulfilling the taxpayer’s obligations.

With the help of the automated systems, the government could tie customs operations to the taxpayers’ income and optimize risk assessment to speed up customs clearance procedures for goods of trustworthy importers.

Tanzania’s tax policy reform significantly simplified all compliance processes and eliminated the inconveniences that entrepreneurs had previously experienced when interacting with regulatory bodies.

In April 2021, the government announced the plans to introduce electronic tax collection technology in the island state of Zanzibar. The island’s Revenue Council expects the move to increase budget revenues from 46 billion to 55 billion Tanzanian shillings and finally eliminate income-hiding schemes by businesses.

Vietnam aimed the tax reforms in creating a rational tax system for the country’s changing economic conditions. Transformation involved the unification of the tax rate structure, cancelation of the several tax exemptions, including privileged conditions for sellers of domestic goods, and costs consideration when calculating the taxable base.

Country tax authorities faced a major change in their structure and organization. Today, a single information system integrates all regulatory services that provide a key functions of the tax administration. Such measures required an increase in staff qualifications and led to the creation of tax colleges.

The successful reform of the country’s tax system made it possible to increase procedural transparency and create a favorable environment for the economic growth. Algeria’s tax system has undergone several changes. The last change happened in 2007, when the government introduced the Single Flat Tax as a replacement for three different taxes at once. The government’s need to simplify the country’s tax system and increase its efficiency along with the transparency, accessibility, and fairness of tax administration were driving these reforms.

Conclusion

To ensure high tax collection, governments should raise the level of financial literacy among taxpayers to create a responsible tax culture. Authorities must patiently explain to the public that taxes are a social contract and make up a purchase of social benefits. They are not the government’s attempt to reach into a citizen’s pocket.

Another crucial step is to ensure that tax rates are reasonable, fair and just for everyone. They should be acceptable to the taxpayer and not tied to income level.

As a part of the social agreement, a failure to comply with the obligation to pay taxes must cause inevitability of punishment with no exception. The tax administration system should be able to identify anyone who does not pay taxes and enforce them to comply, regardless of social status and income level.

It is also particularly important to ensure transparency in the goals, processes, and outcomes of tax spending. If the taxpayers understand where, how and on what government spends their taxes, and experience improvements in the surrounding environment and community, then that will ensure loyalty to the tax system and motivate future conscientious payment of taxes.

The last step towards the formation of a sustainable tax system is to reduce the human factor on the operational level. Full automation of the calculating and paying taxes will reduce the level of corruption in state institutions, eliminate speculation and turn tax payments into a simple, understandable process. Ideally, the automated tax system should communicate with the taxpayer directly without the human involvement of the tax inspector. All estimations and accruals should be based on the data automatically received from diverse sources, and the system should be able to recognize the violations automatically, and launch enforcement processes to eliminate them.

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