| Abstract: |
This paper explores the possible ways in which the emerging market and
developing economies (EMDEs) can improve their tax-to-GDP ratio using a
theoretical framework. We do this using a Laffer curve analysis at the
balanced growth path. We develop a closed-economy discrete-time neoclassical
growth model with heterogeneous agents, and three sectors: households, firms,
and the government. This model is calibrated for a typical EMDE and it
incorporates two well-documented features that limit their tax capacity. The
first feature we model is the presence of a large proportion of the economy
that neither pays nor files taxes. To address this, our model includes
heterogeneous agents, represented by Ricardian and non-Ricardian households.
Non-Ricardian households belong to the informal sector and are entirely exempt
from taxes, while Ricardian households may choose to comply with tax
obligations, creating a partially endogenous framework for tax evasion. The
second critical feature is the relative weakness of institutions in the EMDEs
as compared to the advanced economies (AEs). We incorporate aspects such as
the probability of audits, penalties for evasion, and the culture of
corruption in a minimalist way to capture the essence of the realities of weak
institutions. We derive the expression for the Laffer curve for three types of
taxes: the labour income tax, the capital income tax, and the consumption tax.
We find that the fiscal policies attuned towards bringing a higher percentage
of agents under the ambit of tax collection - despite households evading taxes
- significantly boost the tax revenues. The model clearly shows that countries
with weaker institutions will have a lower tax capacity, as any increase in
the tax rates reduces tax compliance and increases tax evasion. Finally,
reducing the income tax exemptions, decreasing the share of informal sector
firms and employees, and strengthening the institutional quality are essential
for improving the fiscal space in the EMDEs. To our knowledge, no coherent
neoclassical growth model exists in the literature that effectively captures
these features within EMDEs. |