WIDER Elites conference 12 June 09
When Do Elites Pay Taxes? Tax Morale and State-Building in Developing Countries
Max Everest-Phillips[1]
Abstract
This paper argues that the international community should pay greater attention to the intrinsic willingness to pay taxes (‘tax morale’) of élites in developing countries. The political settlement between élites over how to raise public revenues is critical for state-building, by creating élite tax morale and élite attitudes to constructing the social contract between the state and its citizens over taxation. These processes shape the structure of elites and the political commitment to development outcomes, and form the ‘quasi-voluntary’ tax compliance required for effective and efficient tax systems. Elites need effective tax systems to fund the state’s sustainable capacity to enforce their own secure property rights on which long-term economic growth depends. So if élites are not prepared to tax themselves, prevent élite free-riding and invest in promoting tax morale, national political ownership in developing countries of the international community’s development aspirations is problematic.
In developing countries with universal suffrage but extremes of inequality, tax system complexity that facilitates tax evasion and avoidance has replaced repression as the cost-effective way élites contain populist challenges to their power base. Understanding this requires development agencies (that are increasingly recognising the state-building significance of taxation) to pay attention to the political dynamics that underpin élite tax morale as critical for sustainable capacity building in revenue authorities.
Reflecting insights from ongoing tax reform programmes, this paper offers operational guidance for the design of state-building tax reform to strengthen élite tax morale and compliance. This paper concludes that the international community should use tax morale as an indicator of the credible long-term political commitment of élites to good governance, economic development and the Millennium Development Goals (MDGs).
1. Introduction: From Capacity Building to State Building
‘How people are taxed, who is taxed, and what is taxed tell more about a society than anything else.’[2]
‘Variations in the difficulty of collecting taxes … resulted in the principal variations in the forms of European states’.[3] The state needs revenue to function; how that revenue is raised not only reflects the relationship between society and the state, it also helps to fashion it. In the last few years research has picked up this observation to focus attention on the importance of tax as ‘state-building’ in developing countries (Fjeldstad 2003; Moore 2007; Brautigam et al 2008). As a result, the international development community has started to recognise that taxation is a fundamental part of the process of building the effective states and markets on which the ‘exit from aid’ depends (GTZ 2005; DAC 2008; Everest-Phillips 2008; Everest-Phillips and Sandall 2008). As the OECD secretary-general told the UN Financing for Development conference at Doha in November 2008:
“taxation matters for effective state-building. Bargaining between governments and taxpayers plays a central role in the emergence of democratic governance. Citizens want more responsive government. They want the state to be accountable for its actions or inaction and taxes are the vital link between governments and societies. Improved tax relationships between state, businesses and society have provided a strong underpinning for broad-based growth and state accountability”.[4]
Promoting capable, accountable and responsive government is not simply a technical task of putting the right institutions in place, but depends fundamentally on changing the nature of political incentives so that political leaders and elites have a shared fiscal interest in becoming more capable, accountable and responsive. The root cause of weaknesses in tax systems in developing countries is ultimately not poor tax policy or capacity constraints in tax administrations but the lack of political agreement among those with political power and influence (the ‘élites’) to make taxation effective. In effective states such as advanced democracies many citizens are taxpayers and, all citizens being voters the state must develop high trust and credibility with the population. But many developing states have weak institutions and no or limited democratic legitimacy exacerbated by high inequality. In such contexts, elites may not trust in the state’s long-term development prospects, yet control much of the assets of society. Elites fear an effective tax system as threatening redistribution not just of their wealth but, more importantly, of their power base. Creating effective tax system is therefore a collective action problem (how to fund public and collective goods). Any solution to this depends on rulers' and elites’ discount rates or time horizons; on the transaction costs involved; and on their relative bargaining power.[5]
Effective and efficient taxation requires establishing ‘quasi-voluntary’ tax compliance based upon a consensus on national purpose, combined with a sense of fairness that rulers deliver their promises. Tax is also, of course, the art of the possible: taxpayers not only need to be convinced that tax is fair and represents some sort of value for money; they also need to be convinced that other taxpayers are also complying (no free-riding). Elite capacity for tax free-riding (through evasion, avoidance and exemptions) is only efficiently counter-balanced if elites share the political conviction that paying taxes is a productive investment in their own and the country’s long-term future. Effective and efficient taxation therefore requires elites to believe that paying taxes is a civic responsibility to fund social, political and economic development.
Elite attitudes towards the purpose of the state and what type of state taxation should fund, are therefore critical for an effective tax system.[6] Too often however tax reforms are focused only on implementing solutions to technical problems without paying adequate attention to overcoming the underlying political economy constraints crucial for long-term building of an effective state (e.g. Fjeldstad and Moore, 2009). The focus of this paper on the institution of élite attitudes to taxation is therefore motivated by the need to rectify the current inadequate attention paid by development agencies to addressing the politics behind effective tax reform. The aim is to complement the attention in current tax reform programmes given to administrative capacity constraints of tax administrations in developing countries (e.g. Sánchez 2006).
Better taxation systems, better states
Sound and fair domestic taxation systems both promote and reflect good governance because it is hard to raise tax efficiently without citizens’ consent. Bargaining between rulers and taxpayers increases both the state's capacity to collect and administer taxes, and its accountability to citizen-taxpayers. Then governments have incentives to promote broad economic prosperity as this increases the tax base; while negotiation with taxpayers encourages political transparency, as well as better public policy and spending. So tax reforms can stimulate governments to be accountable and responsive to the demands of citizens and civil society, including representative organisations such as business associations. This in turn can stimulate greater government capability, building a more legitimate and effective state.
Effective tax systems are associated with a strong, developmental state: "That a strong positive correlation exists between tax extraction and level of development suggests that overall, the negative effects of excessive state scope are in the long-run counterbalanced by the positive effects of greater administrative capacity".[7] Political ideas, interests, incentives and identities are constructed by leaders and élites through the tax system. Concepts such as citizenship, fairness, trust and equality develop practical manifestation through taxation: 'the tax system is therefore a very effective way of articulating assumptions about the market, consumption and social structures'.[8]
So an effective tax system is an investment in the public goods which the economy and society need, not just the cheapest cost but the right quality.
The state and elite tax compliance
Elite choice in promoting or thwarting tax compliance is at the heart of the development challenge. Donor efforts increasingly focus on enhancing the accountability of political elites for development outcomes in developing countries. Elites are those small groups of people who, formally or informally, exercise power and influence decision-making, through some formal or informal system of authority and accountability, and by control of resources. Elites are not homogeneous, can be governing or politically competing, but can be identified as those persons with disproportionate influence over policy who can generate, accept or block institutional reform. Elites develop formal or informal political coalitions horizontally or vertically in society, to overcome collective action problems. Whether elite coalitions prove predatory or developmental depends on creating political consensus on collective purpose, in part through agreement between political and economic élites over the efficient raising and effective use of public revenues for development depends (Nerré 2002).
Elites therefore, in both commitment to revenue raising and capacity to apportion or appropriate public expenditures, are central to the construction of state-building tax systems that support economic development and political stability. As Moore (2007, 14–15) puts it:
“[…] if state élites need to depend on general taxation because they lack alternative, easier revenue sources, they generally have to put considerable organisational and political effort into obtaining the revenue, and face strong incentives to bargain and negotiate, directly or indirectly, with at least some taxpayers, rather than simply to extract revenue forcibly. In other words, dependence on general taxation provides incentives for state élites and taxpayers to resolve their differences through bargaining.”
Tax morale
The state-building outcome of that bargaining depends on how ‘tax morale’ (inherent willingness to pay taxes) and tax compliance emerge and develop. Attitudes to the legitimacy of the state, the extent of corruption, voice and accountability are critical to trust in the state on which economic growth depends. 'Tax effort' and tax collection depends not just on the income base but also on the political and institutional bases, specifically the extent to which taxpayers trust their governments (Bird, Martínez-Vazquez, and Torgler 2006). Taxpayers are more compliant than the traditional economic models of effective coercion and deterrence predict.[9] Deterrence predicts too little compliance and too much tax evasion (for an overview, see Alm, 1999; Torgler, 2002). Torgler (2005) shows that deterrence does not often affect tax morale significantly. A recent upsurge of attention to tax morale in OECD countries has started to resolve this puzzle by showing a strong correlation between tax morale and tax evasion or compliance (Torgler 2007).
Tax morale however too often remains a residual explanation of tax compliance without adequate analysis of the factors that shape tax morale. Citizens’ tax culture and morale are significantly and positively associated with their perception of the benefits derived by society from the public delivery of goods and services, weighted against the risk of free-riding by others (Everest-Phillips and Sandall 2008). Torgler et al 2008 looking mainly at OECD countries show that institutional quality has a significant influence on tax morale: ‘if the governance quality scale rises by one unit, the percentage of persons reporting the highest tax morale level increases between 8.4 and 11.2 percentage points.’[10] The strongest governance effects were in ‘voice and accountability’ and ‘rule of law’: an increase in the voice and accountability scale by one unit raised the probability of reporting the highest tax morale level by 11.6%; and for rule of law by 9.4%.[11] Similarly, the level of trust in government also proved statistically significant with marginal effects between 2.1 and 2.8 percentage points.
The political governance determinants of tax morale in different contexts are therefore significant. Although little research has yet been done to study tax morale in developing countries, the importance of governance quality and political processes are likely to be the decisive factors. (Nerré 2003; Everest-Phillips 2008). In developing country contexts, where often huge inequalities, weak government capacities and the economy controlled by narrow elites often limit the prospects of improvements to both administrative capacities and to tax morale. Yet tax morale is poorly understood even for developed countries with usually stronger governance contexts (Torgler 2007). Even fewer studies have analysed tax morale and the fiscal sociology in developing countries.
The result is that not enough attention is yet paid to tax morale in different contexts across the global South where widespread inequalities and informality make elites the core tax base. Elite tax culture and morale underpins the complex relationship between the tax authorities and taxpayers reflected in a country’s ‘tax culture’ (Frey and Holler 1998; Nerré 2003; Torgler 2007). Elite attitudes shape every aspect of tax system. The weaker elites’ grip on political participation, the more important the ‘fiscal social contract’ (the accountability of the state for its use of tax, in return for citizens’ acceptance of their fiscal responsibility), and the higher citizens’ tax morale (at least in Swiss Cantons).[12] In highly unequal societies with weak democratic processes, what is unclear is how the tax culture and tax morale of elites shape the final levels of compliance in society. This paper suggests the attitudes and behaviour of elites is a critical factor. The premise of this paper’s focus on élite tax morale is four-fold:
1) Capacity-Building of tax administrations is necessary but not sufficient: effective tax systems require a state-building approach that promotes the institutional structures on which élite tax morale develops;
2) Political, economic and social context shape the attitudes and behaviours of the state and élites to taxation;
3) The institutional and organisational patterns of taxation arise from and are continuously shaped by inter-élite conflict, negotiation, and co-operation and power configurations within the historical framework of the ‘political settlement’; and
4) The interplay of formal and informal élite politics with the social contract over tax explains the changing patterns of elite tax morale and resulting tax incidence (who pays) in different political contexts.
Taxpayers and elites are largely the same groups in poor countries but with two caveats. First, poor people and non-elites still pay a lot of taxation, especially local taxes (often in the shape of licenses and fees): however, since these forms of taxation are collected primarily from intermediaries controlled by elites the 'interface' of the tax system is primarily with the latter and their cooperation and support is essential. Second, in too many countries there are still conspicuously non-taxable elites resembling the untaxed privileged groups in pre-revolutionary France. Such elites, as one infamous rich US tax evader once said, think 'taxes are for poor people.'