Taxation and Informality

Po L i C ies A n D i nstitutions th A t Distor t r esour C e A LL o CA tion in s ub- sA h A r A n Afri CA 61

security, and poverty reduction goals. Such a comprehensive strategy may include ISPs if they can be implemented according to “smart subsidy” criteria. Other important elements of such a strategy include (a) greater public investment in coordinated systems of agricultural research and development (R&D); (b) water management and extension that emphasize bidirectional learning between farmers of varying resource constraints; and (c) input from agroecologists, researchers, and agrodealers (Goyal 2018).

Overall, reforming the design and implementation of ISPs while rebalancing government spending in favor of high-return core public goods and policies could deliver high returns for Sub-Saharan African agriculture systems. Effective science and extension programs are also necessary to interactively work with farmers to identify best practices for maintaining and increasing crop productivity amid changes in economic and biophysical environments.

Taxation constitutes an important source of misallocation, because it interferes with the equalization of marginal products across firms. Tax systems may induce sizable productivity losses. The productivity cost of tax-induced distortions is particularly high in emerging and low- to middle-income economies, where resource misallocation is more pervasive and firm-level productivity more sensitive to distortions (Bento and Restuccia 2017). This implies that tax systems are an even more sizable source of productivity losses in low-income countries than in high-income countries. Tax disparities between productive capital and real estate alone account for as much as a 5–7 percent loss in industrial TFP in emerging and low-income economies (IMF 2017).

Production inefficiencies induced by taxes are amplified if the tax wedges in marginal products across firms are positively associated with their productivity. These production inefficiencies take place if, as a result of taxation, the size of the most (least) productive firms is smaller (larger) than the one indicated by the efficient allocation. This “taxing the good” misallocation is starker in Sub-Saharan African countries relative to countries in other regions. Firm-level data suggest estimated distortion elasticities of productivity of 0.53 for Ethiopia, 0.44 for Ghana, and 0.52 for Kenya (Cirera, Fattal-Jaef, and Maemir 2018).

These “correlated distortions” alter the allocation of inputs and reduce the incentives to invest in innovation (Gabler and Poschke 2013; Ranasinghe 2014). This dynamic inefficiency is likely to both further depress aggregate productivity and widen the efficiency gap between high-income and low- to middle-income economies.

Most distortions caused by tax systems in low- and middle-income countries arise from size-dependent policies and informality. These distortions do not emerge from built-in differentiated effective taxation across assets or sources of financing but rather reflect either de jure statutory provisions (related to the scale of operations) or de facto differentiated treatment (resulting from incomplete enforcement). In the context of low-income countries, size-dependent policies and informality issues are therefore the most salient mechanisms through which taxation causes misallocation and hinders productivity. These distortions hamper the expansion of efficient firms and contribute to the survival of inefficient ones, resulting in lower aggregate productivity.

Size-Dependent Tax Policies

Size-dependent policies interfere with factor demand by (implicitly or explicitly) subsidizing or taxing firms based on their scale of production, thus distorting the size distribution of firms. These policies feature pervasively in tax codes of high-income and low- to middle-income economies alike.

Size-dependent provisions also generate implicit marginal taxes that vary with the scale of operations. For instance, if size-dependent regulations are being phased in as firms expand while licensing, they act effectively as quotas. They create disincentives for firms to grow and take full