Does Law Matter for Tax Collection in Developing Countries?

Written by guest blogger, Wei Cui.


 

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How much does law—legal institutions, legal rules and norms, and behavior oriented towards them—matter to tax administration? In advanced economies, we take it for granted that taxation is governed by the rule of law. Indeed, a fundamental reason many people would offer for why they pay tax is that doing so is required by law. Economists have also produced evidence that the growth of tax revenue in the 20th century in all developed countries was entirely driven by taxes that require self-assessment and voluntary compliance. Voluntary tax compliance and self-reporting are, of course, rule-following behavior par excellence.

However, when economists study tax administration in developing countries, they are very ambivalent about what role to ascribe to legal norms and institutions. Many simply equate rule-compliant behavior with being in the formal sector. Others vaguely surmise that judicial monitoring may benefit tax administration. Perhaps revealingly, many recent empirical studies emphasize the importance for governments to obtain information about taxpayers’ activities. But if the government possessed perfect information about taxpayers, self-assessment and voluntary compliance would not be necessary. So economists appear to be more interested in substitutes for law-abiding behavior than in such behavior itself.

In a recently published article in the University of Toronto Law Journal (“Administrative decentralization and tax compliance: A transactional cost perspective”), I present an example that may help shake up our intuitions about the relation between law and tax administration in developing countries. I describe a country with one of the smallest informal sectors in the world, a reasonably high level of literacy, and a reasonably advanced financial sector (by developing country standards). The country also appears to have collected tax revenue successfully in the last twenty years, with tax revenue growing faster every year than an already very fast-growing GDP. Yet this country’s tax system relies very little on self-assessment and voluntary compliance. Its administrative practices are also often in conflict with legal norms. So the example allows one to separate law-related institutions and behavior from other factors that might determine the outcome of tax administrations: in respect of the role of law much more than in respect of these other factors, the country differs sharply from developed countries. What difference does this make to the country’s tax system?

The country I describe is contemporary China. China’s tax system is surprisingly under-studied by both legal scholars and social scientists, so my description needed to proceed through several steps. I first argue that China’s tax system is highly distortionary because it does not rely on self-assessment and voluntary compliance. For the taxes that generate the most revenue, tax agency officials play a very intrusive role in determining taxpayers’ liabilities. To enable tax collectors to play such a role, much of tax policy design has to be compromised. And where the government cannot play such intrusive role, little tax is collected.

I then address the question of why there is so little self-assessment and voluntary compliance in Chinese taxation. My hypothesis is that the organization of Chinese tax administration inadvertently precludes a lot of voluntary rule-following behavior. While the size of tax administration relative to population in China is only half of that of Canada (0.8 tax collectors per thousand working-age person in China versus 1.69 tax collectors in Canada), most Chinese tax collectors are placed in a dense network of local tax offices. They work hard to ensure that taxpayers in their local jurisdictions register for tax purposes and pay some tax—which probably explains the small size of China’s informal sector—but are ill-positioned to specialize and follow the development of increasingly complex tax law. In the meantime, Chinese taxpayers are much more likely to have personal interactions with their tax administrators on a routine basis than in Canada. It is these local tax administrators that determine their tax liabilities, so taxpayers are much more interested in what these local tax administrators think than what the law says. These frequent interactions encourage a mode of tax collection—and dispute resolution—that is often informal and in deviation from legal requirements. I call the behavior that results “quasi-compliance”: taxpayers are compliant, not with legal requirements, but with local tax administrators’ views of what is required.

The phenomenon I describe is potentially quite significant for developing countries. It implies that there may be substantial trade-offs between different tax administration goals: registration, meeting revenue targets, and taxpayer service, on the one hand, and inducing voluntary compliance, on the other. Conceivably, how citizens deal with the government in tax compliance may also have spillover effects on other realms of compliance. More detailed empirical investigation thus seems desirable. The research is consistent with the idea that the rule of law has micro-foundations, and legal scholars should aim to discover them through empirical inquiry.


Wei Cui’s article, “Administrative decentralization and tax compliance: A transactional cost perspective″ appears in Volume 65 Issue 3 (Summer 2015) of the University of Toronto Law Journal. Read it today by clicking here: http://bit.ly/utlj653b