Tax Capacity and Tax Effort: Extended Cross-Country Analysis from 1994 to 2009

An effective tax system is one of the essential factors for successful country development. The first step to understand the performance of public revenue systems is to establish some commonly agreed performance measurement and benchmarking which can be applied across countries. In this regard the paper focuses on the concept and empirical estimation of countries’ taxable capacity and tax effort. This paper is the second part of Le, Moreno-Dodson, and Rojchaichaninthorn (2008) and intends to develop further country tax effort typologies in order to better respond to multiple requests for tax policy advice emerging from developing countries' policy makers. The actual tax to GDP collection ratio of a country is generally interpreted as a measure of tax collection performance and used as the basis for cross country tax comparison. The use of such ratio is reasonable if one attempts to establish trends or to compare tax revenue performance across countries with similar economic structure and at the same level of income. However, when used to compare the effectiveness in revenue mobilization across countries in different income groups, the tax-GDP ratio could provide a “completely distorted” picture due to different economic structures, institutional arrangements, and demographic trends. A number of tax economists have attempted to deal with this problem by applying an empirical approach to estimate the determinants of tax collection across countries and identify the impact of such variables on each country’s taxable capacity. In order to estimate tax capacity from a sample of 110 developing and developed countries during 1994-2009 and the two sub-periods of 1994-2001 and 2002-09 the paper extends the empirical methodology applied by Tanzi and Davoodi (1997), and Bird, Vazquez, and Torgler (2004). The estimation results are then used as benchmarks to compare taxable capacity and tax effort in different countries. Taxable capacity refers to the predicted tax gross domestic product ratio that can be estimated with the regression, taking into account a country’s specific economic, demographic, and institutional features. Tax effort is defined as an index of the ratio between the share of the actual tax collection in gross domestic product and the predicted taxable capacity. The use of tax effort and actual tax collection benchmarks allows ranking countries into four different groups: (i) low tax collection, low tax effort; (ii) high tax collection, high tax effort; (iii) low tax collection, high tax effort; and (iv) high tax collection, low tax effort. This classification is based on the benchmark of the global average of tax collection and a tax effort index of 1, corresponding to the case when tax collection is exactly the same as the estimated taxable capacity. The analysis provides guidance for countries with various levels of tax collection and tax effort. The authors argue that while taxation is always a critical dimension of fiscal policy for all countries, countries at various stages of development and with different initial levels of tax collection and effort should rely on different strategies for tax reforms. The analysis focuses on tax performance and provides broad directions for tax reform in developing countries.