Structural transformation and tax efficiency

• Author: Jan Gottschalk,Pooja Karnane,Laura Jaramillo,Serhan Cevik,Mousse Sow,Eric Hutton
• Published date: 01 December 2019
• DOI: http://doi.org/10.1111/infi.12346
• Date: 01 December 2019

DOI: 10.1111/infi.12346

ORIGINAL ARTICLE

Structural transformation and tax efficiency

Serhan Cevik

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Jan Gottschalk

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Eric Hutton

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Laura Jaramillo

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Pooja Karnane

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Mousse Sow

1

1

International Monetary Fund,

Washington, District of Columbia

2

Parity Partners, New York, NY

Correspondence

Serhan Cevik, International Monetary

Fund, 700 19th Street, NW, Washington,

DC 20431, USA.

Email: scevik@imf.org

Abstract

Structural transformation has resulted in an increasing

share of services in output and employment in advanced

and developing countries across the world. We analyse the

impact of this shift into services on countries' efficiency in

collecting the value‐added tax (VAT). The analysis is based

on two alternative measures of VAT productivity: (a) the

VAT C‐efficiency, using a broad panel of 134 countries over

the period 1970–2014 and (b) the VAT gap using a more

granular, proprietary data set that draws on the results of

the International Monetary Fund's (IMF's) Revenue

Administration‐Gap Analysis Program covering 24 coun-

tries over the period 2004–2016. We find that a higher share

of services in aggregate value‐added reduces the VAT

efficiency, and that this adverse effect is mainly a result of a

rise of nontradable services which in turn contributes to a

narrowing of the VAT base.

KEYWORDS

C–efficiency ratio, structural transformation, tax efficiecy, tax gap,

value‐added tax

JEL CLASSIFICATION

E32, H2, H21, H25

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INTRODUCTION

Structural transformation has resulted in a rising share of services in aggregate value added in

both advanced and developing countries. Between 1970 and 2014, the share of services in GDP

increased by over 10 percentage points in both advanced and developing countries—with

nontradable services having a rising proportion—and the share of manufacturing has fallen in

the case of advanced economies and stagnated among developing countries

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(Figure 1).

International Finance. 2019;22:341–379. wileyonlinelibrary.com/journal/infi © 2019 John Wiley & Sons Ltd

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Furthermore, both services and manufacturing sectors have become more intensive in services

inputs.

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While there is a growing literature on how structural transformation affects

productivity growth and human capital accumulation, little research has been done on how

structural transformation affects tax efficiency over time and across countries.

In this paper, we examine empirically whether structural transformation alters a country's

efficiency in collecting taxes, as structural transformation encompasses many dimensions that may

have diverging effects on a country's tax efficiency. Structural transformation is associated with a

higher level of per capita GDP and greater institutional development that are likely to result in

improvements in tax revenue collection. Controlling for the quality of institutions, revenue

mobilization typically improves as countries reduce their reliance on a large agricultural sector

dominated by small farms and a large informal sector. However, changes in consumption and

investment patterns may have an adverse effect on tax revenue performance if the tax administration

fails to adapt by removing exemptions and improving compliance in services. For instance, services

sectors tend to benefit from a broader spectrum of exemptions in taxation than manufacturing.

Structural transformation towards services may shift traditional forms of employment to

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1970 1980 1990 2000 2010

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FIGURE 1 Structural transformation:(a) Share of services in total value‐added, percent (b) Share of non‐

tradable services in total value‐added, percent. The solid lines and shaded areas denote the simple average and

interquartile range across countries, respectively, for the sample comprising 42 advanced and 92 developing

countries. Disaggregated value‐added data is not available before 1995 for developing countries. Source:UN

Value‐Added Database, Authors' calculations [Color figure can be viewed at wileyonlinelibrary.com]

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self‐employment, which may be more difficult to tax. Furthermore, if the economy shifts into lower‐

productivity services, this could lower aggregate growth, and thereby affect taxation.

We use panel regression analysis to explore how an increasing share of services in the economy

affects the VAT efficiency. We focus on the VAT because it has become a major source of government

revenues across the world, and because there are well‐defined measures to depict its performance. As

of 2017, there were 118 countries with a VAT in place (Table 1). The VAT is levied on the sale of

goods and services and, therefore, the ultimate base of the VAT is final consumption. Accordingly, the

VAT efficiency captures the departure of actual VAT revenues from the revenues that would be

yieldedbyaperfectlyenforcedtaxleviedatauniform rate on all consumption of goods and services.

We rely on alternative measures of VAT efficiency, with different levels of granularity and

across two separate databases:

1. VAT C‐efficiency. This is measured as the ratio of actual VAT revenues to the product of the

standard rate and final consumption. We use a panel data set that covers 134 countries,

including both advanced and developing economies, from 1970 to 2014.

2. VATgap,compliancegap,andpolicygap. We draw on the estimates of these gaps from the IMF's

Revenue Administration Gap Program (RA‐GAP) framework applied to 24 countries over the

period 2004–2016. The VAT gap is measured as the difference between potential revenues and

actual revenues.

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For greater insight into the drivers of the VAT gap, it can be decomposed into a

compliance gap and a policy gap (Hutton 2017; Keen, 2013). While the compliance gap shows the

effectiveness of revenue administration and taxpayer compliance, the policy gap captures the

impact of tax policy choices, such as adoption of differentiated rates and exemptions.

In an empirical analysis of this nature, it is necessary to address the issues of omitted

variables bias and reverse causality. Accordingly, we use the two‐stage least squares (2SLS)

methodology with instrumental variable (IV), and we also implement dynamic modelling with

the system generalized method of moments (GMM) approach to take into account persistency

in measures of tax efficiency over time.

Our results indicate that existing VAT regimes in both advanced and developing countries will

be increasingly challenged by structural transformation that narrows the VAT base. First, an

increase in the share of services in aggregate value‐added reduces VAT C‐efficiency. Second, the

effect is significantly higher in advanced economies than in developing economies. Third,

the adverse effect is mainly a result of the rise of nontradable services, such as accommodation and

food services, healthcare and social services, and public administration and security‐related services.

These findings reveal that in several countries nontradable services are subject to favourable tax

treatments: nonmarket services (such as public education and public healthcare) are typically

exempt from VAT, and hospitality services often benefit from reduced VAT rates. Our more

granular analysis confirms that a rising share of services leads to a widening of the VAT gap.

TABLE 1 VAT summary statistics

Advanced Developing

Countries 27 91

VAT rate 17 20

VAT revenue (% of GDP) 7.2 7.0

Note. GDP: gross domestic product; VAT: value‐added tax.

Source: WoRLD database, Global Financial Statistics, OECD Revenue Statistics, Authors' calculations

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