IMPLEMENTING THE 2030 AGENDA:

POTENTIAL AND RELEVANCE OF SUBNATIONAL TAXATION

Ehtisham Ahmad

Bonn

September 2016

OUTLINE

• 2030 Agenda: Sustainable Investment and Growth

• Critical role for public investment and effective service delivery for sustainable local “hubs”

• Interactions between national, regional and local policies (for investment as well as taxation) are important

• Need to balance efficiency, revenue and distributional objectives

• Subnational own-source taxes as drivers for structural change

• The role of administration and institutions—prevent rent-seeking behavior

• Linkages between the national tax framework and subnational options—efficiency and equity

• Local taxes and political economy of transfer design:

• poorly designed transfers can negate incentives to use subnational handles

2

TAXATION AS A DRIVER FOR 2030 REFORMS

Making local “hubs” sustainable

3

SUSTAINABLE DEVELOPMENT AGENDA

• Generate growth in a sustainable and inclusive manner

• Better utilization of resource endowments and labour

• Avoid congestion and informality, and reduce carbon use

• Excessive reliance on metropolitan areas (Santiago, Mexico City, Karachi, Guangzhou-Shenzhen, Jakarta)

• Shift resource use towards smaller, compact sustainable cities better linked to employment and production possibility frontiers

• Role of national and subnational assignments, investments and accountability

• Taxes as drivers of structural change:• Reduce the cost of doing business at national and subnational levels

• Generate incentives to lock in place the new pattern of resource use

• Of course, traditional objective remains to raising revenues at each level of government for public spending and services.

4

GENERAL GOVERNMENT: IS 18% OF GDP ENOUGH FOR SDGS?

5

GENERAL GOVERNMENT REVENUE TARGETS

• 18% of GDP, was an indicative target for MDGs—more may be needed, subject to spending needs and macroeconomic constraints• Chile (2015) around 20%, but additional spending on education agenda

requires additional revenue generation• China 1993 (10%), but almost 20% now;• “rebalancing” to inner hubs for sustainable growth—will require local own-source

revenues for “responsible access to credit”

• Pakistan: in trouble with tax/GDP ratio under 10%

• Mexico 2013 (10.5% non-oil tax/GDP ratio; although 22% including oil)• Major package of reforms in 2013;

• Designed to “stop the cheating” and

• Lay basis for more sustained growth trajectory

• But how to create and finance local “hubs” for Convergence?

6

SUBNATIONAL OPPORTUNITIES AND CONSTRAINTS

• Addressing increasing concentrations of production and income distribution, and regional inequality, congestion and pollution

• Focus on new middle-sized urban hubs• More compact with green spaces

• Better connectivity and cost of doing business

• Green technology

• Financing for investment

• Taxes to shift activities from socially unproductive activities and areas and for central financing for wide area infrastructure;

• Regional and local financing for “spokes”; and local infrastructure and service delivery

• Own-source revenues also for local accountability

• Equalization minimizing disincentives, but not “gap filling” transfers

• Access to credit, as well as political economy and prevention of “game play” across jurisdictions

• Incentives to “pass the buck” (Ahmad, Bordignon and Brosio, 2016, Multilevel Finance and the Eurocrisis)

7

MAKING “HUBS” SUSTAINABLE

• Focus has to be on transaction costs and distance to markets to generate private investment—local infrastructure needed to make national infrastructure effective

• Local infrastructure

• Requires own-source revenues for direct costs, but also access to credit, but revenue bases are typically unevenly distributed

• Equalization systems based on standardized factors, not actual gaps

• Plus effective local services to provide a level playing field for private sector investments

• Water, electricity, sewage, policing, feeder roads, schools and clinics

• Avoiding mirages in the desert (several failed attempts in Egypt, some in China)

8

WHY ARE OWN-SOURCE REVENUES NEEDED AT SNG

LEVEL?

9

POLITICAL ECONOMY CASE FOR SUBNATIONAL OWN-SOURCE REVENUES

• What is own-source revenue? Control over rates or bases at the margin

• Need own-source revenues for sub-national accountability

• At margin, local inhabitants pay for own responsibilities

• Needed to ensure hard budget constraints and accountability by linking subnational liabilities with ability to pay (Ambrosiano and Bordignon, 2006, 2015)

• Reduced reliance on shared revenues,

• provide basis for equalization transfers and

• ensure effective utilization of special purpose transfers

• Access to credit for local investments in a sustainable manner—linked to a “inclusive green growth agenda” supported by tax design

10

POLICY AND ADMINISTRATION

• Does not imply that a local tax administration is needed for each own-source tax

• Piggy-backed arrangements for broad based taxes for intermediate levels (including large metropolitan areas)

• Would generate incentives for sub-national governments to share information with national tax administration

• Incentives and institutions are critical and determine the success or not of assigned administrative arrangements

• often ignored in transplanting from Europe or US

• Unitary states: central legislation of band is possible• Local administration not needed, but local information is an

important consideration

11

12Note: enforcement would include both (1) the maintenance of a common data base on transactions and assets, using tax and third party information, and (2) audit.

REVENUE-SHARING IS NOT SUBNATIONAL OWN-SOURCE

REVENUE

• Very hard to agree on “sharing proportions”• Political economy considerations often lead to asymmetric

solutions, including in Indonesia

• The asymmetric solutions in Spain have intensified inequality and separatist tendencies (e.g.., for Catalunya), rather than reducing them

• Exclusive reliance on revenue-sharing, thus

• Enhances fight over resources

• Asymmetric solutions may be needed (e.g., Indonesia), but opens up pressures elsewhere as the poorer regions fall behind

• Enhances local resistance to change: shifting out of petroleum/coal (the latter is important in China)

13

OWN-SOURCE REVENUES AND TRANSFER DESIGN

• Often local revenue bases are unevenly distributed, and own-source revenues can enhance inequalities

• Need to be complemented by equalization transfers to create level playing field and

• Permit local governments to provide similar levels of service at similar levels of tax effort

• But, badly designed equalization is tantamount to “gap filling” for deficits:

• completely negates incentives to use own-source revenues

14

EQUALIZATION AND INCENTIVE EFFECTS

• Standardized factors for equalization (as in Australia and originally in Indonesia) are consistent with hard-budget constraints and efficient use of resources

• Unfortunately, very few countries use standardized factors—none in Latin America

• Dilemma that natural resource sharing is hard to equalize:

• if “favored” region left out of equalization, intensifies the resulting inequalities, and possibly increases pressures to secede (Ahmad and Brosio, 2016, Lisbon Law School)

• If included in the “equalization” with the use of actual revenues and deficits (to offset the revenue-sharing inequality) converts the equalization transfer into distortive ‘gap filling"

• Negative consequences for incentives for all sub-national entities

15

NATIONAL TAX HANDLES AND LOCAL REVENUES?

VAT reforms and subnational implications

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COORDINATED APPROACH TO TAX REFORMS

Key issues to guide reforms at all levels

• Revenues, the main focus in many quarters; but also

• Incentives are critical

• Firms—induce efficiency of production to be able to compete

• Households,

• Governments at different levels

• Reducing the cost of doing business is a priority

• Poverty and inequality need to be a focus for policy makers

• Rent-seeking and need for own-administration at subnational levels? Global base-shifting?

17

VAT—NATIONAL OR LOCAL?

• Split bases common in UK colonial tradition but problematic• India (goods at the regional level, services at the center)

• Legacy of the Government of India Act 1935 setting out state assignments and carried over in post-Independence countries

• Pakistan central government took over provincial sales tax, (1947, given revenue problems) but gave back the services base (haircuts) to provinces in 1973

• Reinforced by the 18th Amendment, unfortunately, for the VAT (did not exist in 1973)

• VAT split bases add to cascading and additional costs of doing business• Difficult to distinguish between goods and services

• Complexity adds to the cost of doing business, domestic trade distortions and rent-seeking

• Trade distortions

• Cascading

• Invoice “sight-seeing” (Brazil) and rent seeking

• Hard to reform as there are vested interests involved

• Problems In India being addressed with a Constitutional Amendment (Ahmad and Poddar, for the Kelkar Finance Commission and Bagchi Memorial Festschrift 2013) but willingly repeated in Pakistan (18th Constitutional Amendment, 2010)

18

VAT GENERATES INFORMATION TO STOP CHEATING AND BASE

SHIFTING

• VAT information on the value chain critical in stopping cheating in the Income Taxes, • Used by EC in the reference against Apple

• Stopping the cheating key element of the 2013 Mexican tax reform package based on fixing the holes in the VAT• Subnational implications

• REPECOS (small taxpayer regime) managed by the states (95% evasion) integrated with the full VAT (RIF)

• Implications for the design and administration of the VAT, especially the integration of small taxpayers

• Importance of integrating the base (goods and services) recognized in EU, China and India (see chart on page 12)• Particularly important to consolidate information on purchases and sales, and

cross check with other elements of value added: wages and profits

• Also critical to have interface of VAT and income taxes, and joint audit

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WHY SUBNATIONAL BUSINESS/SALES TAXES WERE ABOLISHED IN CHINA?

• Local business/sales taxes could not be rebated on exports, so added to the cost of doing business and reduced competitiveness

• Increasing importance of services in value added

• Sector-by-sector integration with VAT since 2010 proved problematic, because of gainers and losers among local governments and line agencies

• Abolished in one go in May 2016—with full integration with VAT,

• Integration of business tax into VAT creates gainers and losers

• Temporarily supporting local governments with lump-sum and ad hoc transfers has to be replaced by more durable revenue assignments

• Search for new subnational own-source revenue handles—parallels the Indian context

20

CHINA: GAINERS AND LOSERS OF MERGING BUSINESS TAX (SERVICES) INTO VAT

21

INDIA VAT/GST UNIFICATION—SUBNATIONAL IMPLICATIONS

• India (Constitutional Amendment approved by Parliament, August 2016)

• Objective: standardization of rates and bases

• Also effectively removes own-source tax handle from states

• Indian government proposal to phase out compensating transfers not credible without alternative sub-national tax handles

• Multiple tax administrations with a uniform tax policy introduces redundancy, complexity for tax payers and possibility of leakages

• Important to ensure common data base and audit function

Need to revisit alternative sub-national own-tax handles and transfer design

22

PAKISTAN CASE

• Inappropriate assignment to provinces of VAT on services (18th Constitutional Amendment 2010

• Leads to double taxation and loss of full information on value chain, cheating and fraudulent refund claims

• Adds to the cost of doing business

• Holes in the base also limit the revenue capabilities—tax/GDP ratio stuck at around 10%

• Third-best proposals to address revenue needs: turnover tax (IGC/DFID)

• Further add to cost of doing business and

• would be disastrous in the CPEC context as the relative disadvantage of Pakistani production would be accentuated

• Increases incentives to cheat (duplicate administration—different administration model from self-assessment needed for VAT)

23

NATIONAL TAX HANDLE AND SUBNATIONAL OPTIONS: INCOME

TAX

Can the income tax become more progressive with subnational piggy-back?

24

THE PIT PERFORMS POORLY IN EMERGING MARKET COUNTRIES

• PIT can be regressive: typically restricted to wage withholding from the formal sector (including in countries like China and Pakistan)

• Misses out the upper tail and incomes from non-wage sources, such as assets

• In Mexico, adds to the distorting effects of the payroll tax (nómina, largely on the formal sector) levied by both the central and state governments

• Major cause of informality and tax evasion by all sizes of firms and workers (Levy, 2008, Good intentions, bad outcomes.)

• Options for Mexico are relevant for China, India or Indonesia—and emerging market economies in general

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MEXICO: ALTERNATIVE TO STATE-LEVEL PAYROLL TAX (NOMÍNA)

• Levy 2008 Proposal to replace nomína by VAT also see Ahmad (2016)

• But great component of the nomína is at the state level, forming the largest component of state revenues

• Cannot be abolished without an alternative

• Piggy back on PIT (ISR personas) with bound of 1.5% to 3% of PIT base

• Permits elimination of state nomína (reduce labour market distortions)

• consolidate nomína for social benefits centrally in Social security Institution (IMSS)

• Generates incentives for local governments to provide information on assets to the central tax administration

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27

EFFECTS OF STATE PIGGY-BACK ON PIT

• Potential expansion of Federal PIT with state-level asset informationmakes the PIT progressive

• Substantial additional revenues for states, with an expansion of the PIT base

• Incentives for local officials to provide information to SAT, possibly reducing local rates

• Becomes a handle that can be used to gauge state ability to pay for access to credit—and • An important element in strengthening state responsibility legislation

• Can be done quickly with central administration

• But need to revamp transfer mechanisms to avoid regional inequality• Avoid the need for ad hoc transfers that can become “gap-filling”

• Equalization can be introduced: revenue capacities and needs

• Use hold-harmless for political economy purposes

• Limit access to discretionary transfers28

EXAMPLES OF A PIGGY-BACK

29

ProvincialPiggy-backonthePIT

30%centralrate

CaseA:5%abovecentralrate

CaseB:5%belowcentralrate

30% central rate

CARBON TAX AT NATIONAL AND LOCAL LEVELS?

30

31

CARBON TAX MODEL OF EFFECTIVE TAXATION

§ Carbon tax important in generating incentives for producers and consumers—green growth agenda

§ Likely products for a carbon tax: Petroleum/kerosene; coal; gas or intermediates

§ But will have and effect on the prices of other goods• Simple model: closed economy

• te´ = t´(I – A)-1

• Open economy model—distinguish between domestic transactions and importables

' ' 1 ' 1( ) ( )e d d m m dt t I A t A I A- -= - + -

32

DIRECTIONS OF REFORM TO DETERMINE TAX VECTORS

• We use concept of the welfare loss associated with: • an increase in the ith tax

sufficient to raise $ 1 in revenue (see Ahmad and Stern, 1984, 1991)

• Where we use welfare weights:

• e=0 equal weights

• e=5 heavy weight on the poorest

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CHILE—DIRECTIONS OF REFORM—RANKINGS 2014

33

Groups e=0 e=0.5 e=1 e=2 e=5Rents(housesandapartments) 1 1 1 1 1Transportation 2 3 15 21 19Otherservices 3 17 24 24 24Education 4 23 25 25 25Telephoneservices 5 16 22 23 23Hotelsandrestaurants 6 11 16 18 18Textiles,clothingandfootwear 7 7 12 14 8Health 8 13 18 16 10MeatsandSausages 9 5 4 6 9Publicbasicservices 10 2 2 2 2Financialservices 11 14 17 15 14Entertainment 13 26 26 26 27Electricity 14 4 3 5 7

CHILE DIRECTIONS OF REFORM (CONTINUED)

34

Groups e=0 e=0.5 e=1 e=2 e=5Vegetables 15 9 11 12 15Non-alcoholicbeverages 16 8 7 7 6Pharmaceuticalproducts 17 21 21 20 20Dairyproducts,cheeseandeggs 18 10 10 11 13Otherfoodproducts 19 19 20 19 22Gas 20 12 8 10 12Liquor 21 15 6 3 3Fruits 22 18 13 8 5Tobacco 23 25 23 22 21Toiletriesandcosmetics 24 27 27 27 26Fish,crustaceansandmolluscs 25 20 9 4 4Oilsandfats 26 22 14 9 16Fuels 27 24 19 13 11

Source: Ahmad and Viscarra, 2016.

MULTILEVEL EFFECTS CRITICAL FOR A CARBON TAX

§ In both Chile (and India and Pakistan), taxing fuel affects other commodities (effective tax approach essential)

§ Affects lower income households although the rich consume more—issue important with higher inequality aversion

§ Need compensation: but CCTs at local levels can constitute poverty trap—both national and subnational elements involved

§ Alternatives: universal pension (Mexico 2013)

§ Universal health care (Indonesia?)

§ Central component necessary to avoid race to the bottom

§ Subnational component: metropolitan areas may need higher local rates than smaller new hubs

Piggy-back to avoid “race to the bottom”, possibility of higher rate in more polluted areas as well as constituting own-source revenues

35

ADDRESSING FAILURES WITH KEY SUBNATIONAL TAXES

Vehicle tax, Propterty tax

36

FAILURE TO DECENTRALIZE VEHICLE TAX IN MEXICO

Attempts in Mexico failed because of the problems with transfer design and incentive structures

• Incentives to use Tenencía (vehicle taxes)

• State level administration—but

• State rate setting in 2009 led to race to the bottom

• function of design of transfers (access to gap-filling transfers at the margin –6% of the total, Pineda 2015)

• Need federal legislation of base and band, focusing on environmental and distributional impacts (highly progressive)

• Plus congestion charges in metropolitan areas

37

DISMAL PERFORMANCE WITH US-STYLE PROPERTY TAXES

38

• Dismal performance with Predial (property taxes) in Mexico and other Latin American countries• Local administration with state rate setting leads to collusion and

dismal collections, with no accountability• Gap-filling transfers reduce the incentive to use highly visible and

politically sensitive tax tools• Maintain cadaster and valuation at state level / independent

agency• Bands for setting rates by municipalities

• But automatic adjustments for changes in property values could accentuate macroeconomic volatility

• Experimentation in Shanghai and Chongqing largely a failure• Marshallian linkage with service delivery may be better (Ahmad,

Brosio, Pöschl 2015)

WHY DO PROPERTY TAXES PERFORM SO POORLY IN EMES?

• Mexico: states set rates; local governments collect tax, manage cadaster

• Pakistan: provinces set rates and collect

• Also no local accountability

• Problematic incentives—contact of tax collector and powerful individuals

• Weakened by absence of rate setting authority at local level

• No accountability

• Proximity of taxpayers leads to political resistance and “rent seeking” (registration and valuation)

• Local administrators able to do deal with “deserving citizens”, friends and relatives

• Dismal revenue performance

• Cannot be offset by “incentives” to tax collectors (IGC/DFID proposal 2016)

• Indonesia: devolution of property tax in recent years (from shared tax)

• Little effect on accountability at local levels (LPEM/LSE project 2016 forthcoming)

• Poor incentives to use the instrument (GIZ/D.I.E project 2016)

• Very likely due to “gap filling nature of some intergovernmental transfers”39

POSSIBLE SOLUTIONS FOR THE PROPERTY TAX?

• Assign rate setting, not administration, to municipal level

• Avoid race to the bottom by setting minimum and maximum bands

• Cadaster and valuation (independent bodies to avoid rent seeking?)

• Electronic registers for transactions

• Remove direct contact with taxpayers (state or national cadaster; valuation)

• Run functionally based administration (slide 12)

• Self-assessment principles• Experiences from Latin America (Bogotá, Bangalore) forcible purchase of

properties at declared values

• Administration in this case is complex

• Need to establish mechanisms to prevent misuse against political opponents

40

PROPERTY TAX AS BENEFIT TAX

With decentralization, a tax in isolation more likely to generate adverse reactions by taxpayers (Ahmad, Brosio, Jimenéz, 2013)

• With limited information, rent-seeking and collusion possible

• Migration between local jurisdictions is encouraged

• Without benefits, higher taxation in one jurisdiction would be punished, given yardstick competition (Mexico, property and vehicle taxes)

• Voting against the incumbent potential constraint to higher taxes (Seabright, 1996).

• Also involving local media against the tax, easier at the local level

Marshallian tax/benefit link essential to offset negative incentives

41

PROPERTY TAX AS BENEFIT TAX

• Benefit taxes imply zero net tax, the burden of taxation being compensated by benefit of expenditures.

• With zero net tax burden,

• changes in taxes/expenditures are expected not to raise reactions from taxpayers, such as migration, protests, voting out incumbents, or resistance/evasion, including above all move to the informal sector.

• Shift from traditional property tax to benefit ”community charge” in the UK

• Major potential in China, and other emerging market economies

• Sidesteps problems with cadaster and valuation

42

TAXING EXTERNALITIES AT LOCAL LEVEL

43

• Supplement national fuel taxes with local congestion

charges also to fund sustainable growth infrastructure.

• Use of new technologies – GPS and electronic gates – makes

congestion charging accessible.

• Scale the burden according to the different spatial incidence of damage: urban

versus rural areas.

• London, Milan and Singapore examples:

• Congestion fee is applied to vehicles passing through cordons that identify

central and congested areas.

• Considered in Chinese cities, given staggering increase of vehicles in urban

centers.

CONGESTION AND DISTANCE RELATED TAXATION

44

• Correct polluting impacts from vehicle use in congested areas• Provide direct and substantial revenues to urban governments.

• Potential for increase of revenue from property tax.

• Reduced congestion leads to increased residential property values in (formerly) congested area, likely to outweigh reduction of values in other areas

• Increased collections with appropriate re-assessment of property values, or setting of appropriate “bands” with community charges.

IMPACT OF CONGESTION TAXES

45

• Aviation represents one of the fastest-growing sources of

greenhouse gas emissions.

• Providing large and rapidly expanding tax base (444 million

passengers in 2014 in China, expected to become the largest

world market by 2030)—similarly for Indonesia.

• Aviation taxation offers an important new base in emerging

market economies

AVIATION TAXATION

46

§ The main option would replace the per passenger tax with a per

aircraft tax.

§ incentives to airlines to ensure that planes are fully loaded

§ The tax can be scaled according to the fuel efficiency and to the emission of noise

of each aircraft model.

§ The tax can be scaled according to destinations, such as the Americas, Africa or

Europe, with relation to the distance travelled.

§ Piggy-back on centrally determined brackets to reduce risks

of the race to the bottom.

§ Easily be levied on freight flights

AVIATION TAXATION—LOCAL OPTIONS

47

CONCLUSIONS

A political economy story

48

Subnational own taxes needed to provide a permanent source of finance for green-growth investment and to increase accountability.• Magnifies the link between the benefits of expenditures and the tax burden

• Links with access to credit for local investments

• At the provincial level:• Easiest to consider a piggy-back on the PIT for provinces

• Carbon tax piggy-back and

• restructuring of aviation taxation

• At the municipal/county level• Community charge (variant of property taxes) linked to services,

• Excises, e.g., on hotels, tobacco and alcohol

• Congestion taxes and fees.

Have to utilize a reformed equalization system at the national and regional level to make these options work well

POLICY OPTIONS FOR EMERGING MARKET ECONOMIES

49

§ Despite the merits of local tax instruments, § They are unattractive and politically costly when gap-filling transfers are

available.

§ Uneven tax bases reduce incentives to use in relatively poorer jurisdictions

§ A within-province equalization system is needed to make the property and other subnational taxes workable (reflecting the national system)

§ Tax-benefit linkages highlight the attractiveness of Marshallian proposals

INCENTIVES TO USE SUBNATIONAL TAXES

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