Informal economy and black money are created due to three issues related to a taxation system: Low probability of detection in case of non-payment, high compliance costs, and high tax rates. Nepal does not have high tax rates. In fact, the entire South-Asia has one of the lowest tax rates in the world. But the other two reasons are significant in Nepal.
If the probability of detecting a tax-cheater is very low, people will take advantage of the situation and save money by not paying taxes. In Nepal, this probability of detection is very low because we already have a large informal economy. Also, most people get paid in cash which is difficult to trace, and our tax-administration is understaffed and under-equipped. Tax officers are not granted any incentive to increase their productivity and catch more tax-criminals.
If the compliance cost is very high, people will avoid paying taxes. A good tax system should make the taxpayer feel easy about the whole process. It should be like going to a super-market, where you are able to approach a worker when you have any doubts without fear of being judged and punished for your ignorance. You should also be able to make your payments within minutes, and leave the building. But, our current tax system has too many codes, too many dos and don’ts. It is difficult for us to determine, by ourselves, how much we owe to the state in form of tax.
The payment process and refund process take too long to complete. There are no incentives for the past non-payers/defaulters to join the system and start paying taxes. They fear being persecuted for their previous tax evasion. Thus, our tax system is very taxing on people’s patience, and does not encourage formalization of informal economy. These factors, when combined, make the tax paying process very costly. I believe that taxes, like death, should be unavoidable, but the process of paying tax should be much less painful.
Tax in Gross Domestic Product (GDP) ratio in Nepal is only around 13 percent. But the government expenditure on GDP ratio is around 24 percent. Even considering the non-tax revenue into the equation, Nepal spends more than it generates in revenue. This is unacceptable in many grounds, not least of which is the shameful “foreign aid” that we keep receiving to cover this gap.
We should promote a growth-oriented tax system that minimizes the adverse effects of taxes on people’s incentives to work, save and invest. It should foster growth of jobs, savings and investment. It should encourage the formalization of the huge informal economy in Nepal.
Why are we paying only 15 percent in income taxes while people in other countries pay between 20 to 40 percent? Why should citizens of Norway, Sweden or Japan pay for any of our expenses while we refuse to pay more taxes? We need to stop accepting foreign aid, and should raise our taxes. We have no right to ask for a better road, 24-hour electricity and running water if we are not willing to pay for it. It is time we start financing our own expenses. No country has ever achieved economic growth due to foreign-aid. Show me one example, and I will shut-up. Foreign-aid is a band-aid; it is not curing medicine.
The reform in the fiscal mess should start with revamping our tax system. The state should nullify Value Added Tax (VAT) system, if it cannot enforce it fully. Collecting VAT from a handful of honest people, and letting dishonest ones get away with evasion, avoidance and fraud is not a good way of conducting the business of tax-collection.
We should promote a growth-oriented tax system that minimizes the adverse effects of taxes on people’s incentives to work, save and invest. It should foster growth of jobs, savings and investment. It should reduce collection, compliance and distortion costs. It should encourage the formalization of the huge informal economy in Nepal, and should actually provide disincentives for informalization. Do we have such a system in Nepal?
Policymakers and researchers around the world agree that a good taxation system needs to be progressive. It means you should pay more if you make more, but only up to a limit. Researchers have determined that tax rates on income—personal or corporate—should not exceed 35 percent. Once it exceeds that limit, the system creates disincentives to work, save and invest. However, while practicing progressive taxation, governments have been found getting carried away in wrong directions. To fight inequality, governments in poor countries often lower the income level of the rich by taxing them too high. Reducing inequality by turning the rich into poor is the wrong approach. The focus should not be in reducing the income level of the rich, but in raising the income level of the poor.
This brings us closer to another important issue. Often, governments in a poor country, like Nepal, use the tax system and modify tax rates to achieve political or social objectives. This is not a workable approach. It has been proven by many studies around the world. The tax system stops functioning well if you start applying tax-exemptions, like exemptions to agriculture, or lower the tax rates in order to achieve a social or political objective.
Contrary to the belief of many governments, reducing inequality through higher taxation does not reduce poverty. Research has shown that poverty can be reduced only through increased government expenditures. Obtaining social objectives is not the job of taxation system. It is the duty of government’s expenditure system. A good taxation system should have only one objective: To raise revenues.
The writer is an Economist at Institute for Integrated Development Studies
mkhanal@iids.org.np
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