Scope for a Grand Bargain to Reduce Tax Exemptions?

January 07, 2020


Addis tax initiative

The international community–whether  donors or international organizations—is continuously exhorting developing countries, particularly the low-income ones, to mobilize more revenues domestically—also one of the seven actions under the Addis Ababa Action Agenda (AAAA) for financing development adopted in 2015. The underlying rationale is that mobilizing additional resources domestically, when supplemented with limited external flows, would help finance the Sustainable Development Goals by 2030. A quick review of IMF tax data for sub-Saharan Africa (SSA) shows that there has hardly been any increase in the average tax-to-GDP ratio since the Addis Summit. On the contrary however, there has been a modest decline in this ratio.

Until 2015, donors provided little assistance to developing countries to strengthen their technical and administrative capacity in tax policy and systems.This changed at the Addis Summit with the establishment of Addis Tax Initiative (ATI). Initiated by Germany, the Netherlands, the UK, and the US, ATI has 20 donor countries, 24 developing countries, and 16 international organizations, such as the IMF and World Bank as its members. ATI members have committed to doubling their financial support, technical assistance, and policy advice to developing countries in domestic resource mobilization (DRM) by 2020. And since ATI was launched, more resources are being allocated by its donor members to support DRM activities in developing countries.

In this blog post, I argue that the tax concessions that donors receive from developing countries on aid-funded projects are inconsistent with donor efforts to enhance DRM through their financial and other support. There may be a way to cut back on tax expenditures in general if all parties were to enter into an agreement that bound developing countries to curtail them, as long as advanced countries did not seek tax concessions on aid-funded projects/programs.

Tax expenditures

Widespread tax concessions granted to corporations and individuals in SSA continue to hamper the revenue performance of these countries. Technically labeled as tax expenditures, they further narrow the tax base, complicate the administration of the tax system, and create opportunities for corruption. For the limited number of SSA countries for which these estimates are available, tax expenditures average five percent of GDP and can be as high as 40 of overall tax collections. Because tax expenditures are not transparent, it is challenging to gauge their true cost to the budget. This means that even if countries are making progress in raising more resources by broadening their tax bases and improving administration of the personal income and consumption taxes, aggregate tax collections may not expand because of rising tax expenditures.

CGD recently published two studies on Nigeria and Zambia on the political and institutional impediments behind their weak DRM performance. Both studies highlight extensive use of tax exemptions in these countries. Nigeria collects merely one percent of GDP from corporate taxes—a relatively small sum for the largest SSA economy. There are many reasons behind low productivity of corporate taxes in Nigeria, but a key one is tax exemptions granted to politically influential entities in manufacturing, agriculture, solid minerals, oil, and gas. These exemptions have also shrunk the tax base for customs duties and value-added taxes. Nigeria’s overall revenue collection averaged 8.4 percent of GDP from 2014-2017 (of which tax revenues constituted 4 percent of GDP), indicating the magnitude of the challenge that Nigeria faces in meeting the SDGs by 2030. Zambia’s revenue from corporate taxes is higher at two percent of GDP, but it has a generous tax incentive regime which has meant that the most important sector in the economy—mining—pays little taxes.

Tax concessions for aid-funded projects

In addition to politically connected often benefit from tax concessions, most donors get exemptions from paying custom duties and the value-added tax on aid-funded projects in countries where they operate. The cost of these tax concessions depends on the size of aid budget and has been estimated to be as high as three percent of GDP in countries that rely more heavily on aid. The loss of revenue arising from tax concessions on aid is likely to be large in countries reconstructing their economies with external assistance. These countries tend to be fragile, emerging from a war or conflict with a tax ratio of less than 15 percent of GDP.

There are several drawbacks of granting concessions to donors and others:

  1. promotes the culture of exemptions in the economy
  2. impedes a smooth functioning of the VAT by breaking the payment-deduction chain, and since these exemptions are generally granted to foreign enterprises they end-up favoring imported goods
  3. complicates tax administration in countries where capacity to administer tax laws is already weak

The Addis Summit recognized the issues arising from tax exemptions granted to aid-funded projects and called upon the donors to consider not requesting them. Already, there are a few countries that have moved in this direction. As of January 2016, the Netherlands renounced the exemption-seeking policy—a policy that Norway had adopted three years earlier. While the EU endorsed AAAA, it did not agree to a gradual phasing out of such exemptions. In some countries, payment of taxes on aid-funded projects is viewed as providing budget support to aid-receiving countries. Fortunately, the Dutch Parliament did not see it this way.

A grand bargain

Donors are concerned that mounting tax expenditures will eat into the growth of tax bases of developing countries made possible by their assistance and advice, on top of creating distortions in the economy. At the same time, part of the problem arises from exemptions granted to donors. It would seem wise for donors to enter into a “grand bargain” with developing countries by relinquishing exemptions on aid, provided developing countries on their part embrace policies to limit tax expenditures. Such policies could include making tax expenditures transparent, centralizing them in the Ministry of Finance, and embedding them into the law.

Why not have this “win-win” policy as part of the G-7 agenda?


CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.