How countries are deprived of tax revenues

The previous sections explained some of the important functions of tax. The following sections go on to explore how governments are deprived of tax revenues. If tax revenues leak from an economy on a grand scale, this undermines the scope for tax to bring any of the potential benefits described in the previous sections. Lost tax revenue affects all countries, rich and poor, but the impact on countries in the South is demonstrably greater.Many southern countries are affected by a set of common domestic challenges. Revenue authorities are often weak and fail to collect the taxes they should; the size of the informal sector makes monitoring of economic activities and the collection of taxes a huge challenge; and corruption in governments and tax authorities undermines trust and diminishes the incentive for citizens to pay tax.

As if these challenges were not enough, on the international stage the odds are stacked against southern countries. Many southern countries face pressure to adopt domestic policies that can undermine their taxing rights. Some countries have been subject to conditionalities that promote a set of policies known as the ‘tax consensus’ which are highly regressive; tax competition results in countries lowering tax rates or offering tax holidays in the hope of attracting foreign investment. On top of this there is a lack of accountability regarding agreements signed with multinational companies (MNCs), particularly in the extractives sector.

Finally, it is clear that a lack of transparency facilitates grand corruption. Secrecy surrounding the operations of MNCs and the taxes they pay means that companies can easily avoid or evade taxes; and financial secrecy in tax havens makes it easy for individuals and companies to hide financial activities from governments in the South.

The following sections look at the domestic constraints to effective taxation, before addressing external pressure to change tax policy and, finally, financial secrecy leading to tax evasion and avoidance.

Domestic constraints

Weak revenue authorities and large informal sectors

The capacity of tax authorities in southern countries is an area that urgently needs improvement. Traditionally, few resources have been devoted to auditing and it is common for many companies in southern countries to declare losses for tax purposes with few investigations resulting. In addition, the capacity of a national tax authority in a southern country to effectively audit the accounts of a multinational is often extremely limited given the complex accounting practices MNCs can use to allocate profit and loss acrossa large number of subsidiaries in a range of countries. VAT evasion and even basic smuggling are also major problems for southern country tax authorities.

Given that in most southern countries a large proportion of the economy operates in the informal sector, the capacity constraints are all the more pertinent. If individuals and small businesses use cash transactions rather than bank accounts, it is difficult to monitor economic activity. At the same time, individuals and small businesses need to be motivated to register and pay tax. Necessary incentives might include protection of property rights, provision of services and support to save. It is the challenge of the informal sector that can lead governments to implement regressive VAT regimes, as it is easier to collect revenue from consumption than income.

In addition, southern countries generally have an extremely poor record with regard to the investigation and prosecution of tax evasion.?For example, in Guatemala, between 2001 and 2003, 1,295 tax evasion cases were presented before the courts. Of these only four resulted in the defendants being found guilty. In Honduras, a tax authority director went public about receiving anonymous threats over ongoing tax evasion investigations. Many southern countries do not even have a large taxpayers unit (which can reduce tax compliance costs and ensure uniformity in determining tax duties), never mind a dedicated team to track tax evasion cases. The impunity of large tax evaders is a major obstacle in countries where governance is weak, corruption is widespread and the political will to address such issues is non-existent.

This then undermines the willingness of ordinary citizens to contribute to taxes, as they see the wealthy dodging their responsibilities.³¹

Politicisation and corruption in revenue authorities

Within revenue authorities, as with any institution, there is scope for politicisation, corruption and mismanagement. For example, an Indonesian tax official who was just three years into his job was found to have an accumulated wealth of more than Rp100 billion (US$10 million) – impossible?on his monthly salary of about US$800.?An investigation and statements of the disgraced tax official included allegations that several companies linked to a major political figure had bribed the disgraced official in order to evade taxes. Several officials have been convicted in relation to this case.³²

Cases of corruption such as this can undermine public trust in the tax system as well as morale within the revenue authority and can lead to lower levels of tax collection. Such problems are not confined to southern countries.

In addition to these domestic challenges, southern countries face external pressures and constraints in setting domestic policies that would enable them to raise revenue effectively. The international tax system equally represents the interests of the powerful.

External influence on tax policy

Tax competition – the race to the bottom

Tax competition has gone hand in hand with the increasing mobility of capital in a globalised world. Over the past three decades, nation states have tried to attract foreign direct investment through low tax rates and incentives and, in some cases, the promise of financial secrecy. The IMF, World Bank, regional development banks and the European Union (EU) have all, in varying ways through their private sector development work, promoted this trend, by encouraging the lowering of corporate tax rates or granting tax-deductible capital allowances for the mining industry, for example. These sorts of policies together are sometimes collectively described as the ‘tax consensus’.³³

Proponents of tax competition argue that lower tax regimes are essential to attract the investors who will in turn provide jobs, revenue, technology transfer, infrastructure and linkages to domestic firms. However, the role of tax breaks in attracting foreign investors is highly questionable, with a number of cross-country studies concluding that the costs of tax incentives in terms of lost revenue frequently outweigh the benefits in terms of increased productive investment.³⁴ The IMF is now more likely to advise countries to minimise tax exemptions and to ensure that the costs of all tax incentives are explicitly included in national budgets.

Companies attracted by such tax breaks have been regularly criticised for their, often, poor record in terms of worker rights or respect for the land rights of indigenous people. Such investors also often fail to bring the promised technology transfer or other linkages to domestic firms, particularly as World Trade Organization (WTO) requirements make it difficult for governments to oblige companies to do so. Not only does tax competition fail to guarantee inward investment that is pro- development but it is also anti-democratic, as it undermines the ability of electorates to choose between high-tax/high-spend and low-tax/low-spend governments.³⁵ Ultimately, the winners from tax competition are the mobile MNCs that can play governments off against each other in order to secure the lowest tax rates. Ordinary citizens whose governments are deprived of vital revenues are the ones to lose out – and it is the poorest who suffer the hardest.

Special economic zones and maquilas

Governments often grant these extended tax breaks through establishing special economic zones (SEZs), which are geographical regions that have different tax laws to the rest of the country. The category ‘SEZ’ covers a broad range of more specific zone types, including free trade zones (FTZs), export processing zones (EPZs) and free zones (FZs). Maquilas (otherwise referred to as ‘maquiladoras’) are individual factories that operate according to similar terms to SEZs.

In general, SEZs and maquilas have a poor reputation in terms of their labour standards and their record of displacing indigenous people from their land. As citizens agitate to redress these injustices, many also build tax justice into their campaigns.

Tax breaks in the extractives sector

Another area in which tax breaks cost southern countries dearly is the mining and minerals sector. Mineral extraction is renowned for its poor social and environmental impacts. In addition, industrial mining companies are particularly known for failing to create linkages into the local or national economies that would stimulate more private sector development and job creation. This is because foreign mining companies import most of their mining equipment, as well as the technical, financial and managerial services needed to run the mines. Then, once extracted, raw ore is usually exported for further refining or processing elsewhere. Moreover, given the capital-intensive nature of industrial mining, these companies create relatively few jobs. This is why there is a widespread view that the paramount development benefit of mining in Africa is the potential to generate public revenue through tax. Government revenue in the form of royalties, fees and various direct and indirect taxes is potentially a major source of income for governments of countries rich in natural resources.

However, extremely widespread tax breaks mean that this primary benefit too often fails to materialise. Too many MNCs have demanded and received massive tax and royalty concessions from governments as the price of setting up operations. These tax deals are usually made in secret between companies and governments through contracts that often override national tax laws.
This kind of treatment in turn encourages corruption, as secrecy makes it extremely difficult for civil society, parliaments and others to monitor the revenue from extractives and how this money is spent through the budget.³⁸

Trade liberalisation leading to lost trade taxes

Trade liberalisation is another major avenue through which southern countries have faced diminished tax income. Many southern countries rely heavily on taxation of imports, because such taxes are relatively easier to collect and less costly to administer than other forms of taxation. The proportion of a government’s overall revenue that comes from these taxes can be up to one-third, or in some countries even higher.

However, many countries have progressively lowered tariffs during the past couple of decades as a result of World Bank and IMF conditionalities and donor ‘advice’, which has in turn reduced their tax income. And today, bilateral and multilateral free trade agreements threaten to impose additional severe reductions in southern countries’ income from tariffs. For example:

• Based on figures from the United Nations Conference on Trade and Development (UNCTAD), ongoing multilateral negotiations in the context of the WTO Doha Round could result in losses of up to US$64 billion for southern countries, through lost import tax revenues on industrial goods.⁴² This is four times the amount that the World Bank predicts southern countries would gain as a result of increased trade.⁴³
• Free trade agreements being negotiated, or in some cases recently concluded, between the EU and groups of African, Caribbean and Pacific (ACP) countries (known as economic partnership agreements, EPAs) would also impose serious revenue losses for particularly vulnerable countries as a result of foregone trade taxes. Côte d’Ivoire is predicted to lose an estimated US$83 million per year, equivalent to its current health spending for half a million people.⁴⁴

The IMF and others have strongly argued, as part of the ‘tax consensus’, that trade taxes should be replaced with VAT. However, we highlighted earlier that VAT tends to be a regressive tax. In addition, research from the IMF itself has shown that the introduction or expansion of VAT has not generated levels of tax income of anything like the magnitude that would compensate for the lost trade taxes. In least developed countries, VAT and other forms of taxation only make up for about one-third of the taxes foregone through lost trade taxes, according to the IMF’s estimates. This means less revenue for spending on social services.

‘There is no adequate legislation governing transfer pricing in Mozambique. …When there is a request for transfer pricing placed with the tax authorities nobody knows how to deal with the request… It is therefore easy for multinationals to take advantage, to exploit the weak capacity of tax authorities and the lack of regulation governing transfer pricing.’

Financial secrecy leading to tax evasion and avoidance

We have explored how governments offer low tax rates, tax breaks and tax holidays in an attempt to attract investment. We have also seen how foregone trade taxes present a further strain on government coffers. As if these practices did not already drain enough domestic resources, further leakage of potential revenue occurs through international tax evasion and avoidance, which is facilitated by financial secrecy. There are a number of techniques for avoiding tax.⁴⁶

Abusive transfer pricing

It is estimated that 60 per cent of international trade occurs within MNCs, as different subsidiaries sell goods and services to each other.⁴⁷ Although tax dodging is not restricted to multinationals, these companies with multiple subsidiaries operating in different countries can more easily manipulate their taxable profits. One of the key mechanisms through which multinationals get away with non-payment of what they owe to governments is through manipulating the prices that are charged for goods and services within the company but across borders.

Transfer pricing is the system of pricing transactions between related parties, for example sister companies within the same commonly controlled group of companies. MNCs run their businesses on an international basis, and a sale of goods or services to a customer in one country will often involve group entities in several other countries in the supply chain. The problem is how to allocate the cost of producing and selling the product or service and the profit earned on the sale.

International regulations require companies to price goods and services to related companies as if they were unrelated and trading in the open market. However, often it is difficult to determine what a market value for a product is. In this context, a company can set the sale of goods and services by affiliated companies within an MNC to each other at artificially high or low prices.
The companies can therefore often allocate the profit between the trading subsidiary companies in such a way that a minimal amount of tax has to be paid.

Where this occurs within companies, tax justice campaigners often term this ‘transfer mispricing’. A similar practice where unrelated companies make deals with one another to manipulate the price is called ‘false invoicing’. Together these are often termed ‘trade mispricing’. It is estimated that around 50 per cent of trade transactions in Latin America and 60 per cent in Africa are falsely priced by an average of more than 10 per cent.⁴⁸

The victims of trade mispricing are all too often poorer countries where the revenue authorities have neither the expertise nor the resources to monitor or prove what is happening. Secrecy and lack of transparency in financial reporting make it incredibly difficult for under-resourced tax authorities to work out what tax is due to them, because companies are not obliged to report their profits and that of their subsidiaries at all national levels to the governments in whose jurisdiction they operate. On the other hand, MNCs have the resources to carry out complicated global transactions and procedures which tax administrators in southern countries may find difficult to trace.

It is not just the lack of transparency in corporate reporting that facilitates tax evasion and avoidance, but also the lack of cooperation between countries when it comes to sharing tax information. Secrecy jurisdictions undermine the ability of governments to collect revenues by allowing companies and individuals to harbour assets on their shores, away from the eyes of the tax man.

Secrecy jurisdictions (commonly known as tax havens)

Secrecy jurisdictions facilitate the tax dodging outlined above. There are between 50 and 72 of these secrecy jurisdictions in the world, which allow companies and wealthy individuals to hide assets and avoid tax by refusing to effectively exchange information with other countries.
The Tax Justice Network estimates that the total sum of money held ‘offshore’ is around US$11 trillion, resulting in an annual tax loss of US$255 billion. Secrecy jurisdictions deprive the exchequers of rich and poor countries, but they have an immeasurably greater impact on southern countries that can ill afford the losses. In some cases they can provide a hiding place for bribes paid to governments, or assets siphoned from a government’s budget.

Secrecy jurisdictions also allow MNCs and wealthy individuals to set up ‘trusts’ into which money is paid. The identity of those paying money into these tax havens is hidden, as is the identity of those with access to them. This means that if tax is liable on this income, the country where the tax is due may never know.