Chapter

5 Tax Administration

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
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Author(s)
Charles L. Vehorn and Ehtisham Ahmad 

In many developing countries efficient or equitable tax policies may fail because the tax administration is not able to implement these policies (Casanegra de Jantscher, 1986). Consideration of the tax administration dimension becomes even more complex when different levels of government are involved in collecting taxes. Central governments, owing to their size and their resources, have a comparative advantage in collecting revenue, but subnational governments have an advantage in providing residents of the locality with the desired amount and mix of local public goods (Oates, 1972 and 1991).

Given the above considerations, intergovernmental relations in the tax area are affected by two key policy decisions. First, how will the collection of taxes be organized—under central government control, control at one governmental level other than the central level, or multi-level government control? Second, how will the central government provide subnational governments with unrestricted revenue—through tax assignment, revenue sharing, or lump-sum transfers—to meet the demand for locally provided public goods?

The mix of policies to address the above questions varies across countries and over time. However, for developing countries and those in transition to market-oriented economies, a simple system of tax policy and administration is likely to be needed to ensure adequate revenue collections. Any undue complications could result in serious administrative burdens and problems in securing taxpayer compliance, as well as potential revenue loss.

Models of Tax Administration in Multilevel Governments

Tax administration by the central government alone should be distinguished from a structure that allows other levels of government full or partial control of collection. From a macroeconomic perspective, centralized tax administration has clear advantages. If the central government manages all tax administration, tax policies aimed at stabilization of the economy have a higher probability of being implemented as intended. If other levels of government are involved, control over the implementation of tax measures to promote stabilization can be weakened. However, the above argument applies mainly to a subset of taxes, such as the corporate and personal income taxes, and the value-added tax (VAT). Some taxes, such as property taxation, are amenable to local administration without loss of macroeconomic control (see Chapter 3).

There are four basic conceptual models for tax administration among different levels of government: (1) central government tax administration only, with provision of revenue sharing and transfers; (2) central government tax administration only, with assignment of different taxes to different levels of government; (3) multilevel administration, with revenue sharing and transfers; and (4) each level of government administering the taxes assigned to it.1 The first two options centralize tax administration by maintaining central government control over all tax offices, including tax offices at the regional and local level. The third and fourth options permit tax collection by subnational governments. Whether tax administration is centralized, allocated to one level other than the central level, or spread over various levels of government is as likely to depend on political realities as on technical considerations, but there are technical implications associated with different tax administration structures. The purpose of this chapter is to analyze the advantages and disadvantages of centralized versus subnational or mixed forms of tax administration. Examples of country experiences will be drawn on where appropriate.

Administrative Objectives and Costs

In assessing how best to collect taxes, it is important to keep in mind two primary objectives of tax administration: (1) to apply the tax laws uniformly to achieve maximum collection at minimum costs, and (2) to promote voluntary compliance by taxpayers (Inter-American Center of Tax Administrators, 1992).

Uniform application of tax laws across taxpayers demonstrates that the tax administration is committed to the fair treatment of taxpayers. This emphasis on fairness has been identified as one factor that helps to enhance confidence in the tax system and to promote voluntary compliance (LeBaube and Vehorn, 1992). However, the promotion of voluntary compliance entails not only a fair treatment of those who comply, but also rigorous enforcement and swift action against those who fail to comply with the tax laws, for example, by failing to file a tax return, failing to file an accurate return, or failing to issue an invoice as required under a VAT. In some countries that levy a VAT, tax officials have the authority to close a business for a few days and post a sign on the door of the establishment, indicating that the closure is due to noncompliance with the VAT law or regulations. Taxpayers will be more inclined to comply voluntarily if they perceive a risk that noncompliance will be detected and punished. A tax administration that simply attempts to minimize its costs of collection, in relation to the potential revenue cannot be viewed as effective unless it fosters a high level of voluntary compliance (Casanegra de Jantscher and Silvani, 1991).2

When countries select multilevel or subnational tax administration, authority to collect specific taxes should be given to the level of government that is able to function with the lowest collection and enforcement costs (Rubinfield, 1983). In this perspective, the central government should take full advantage of administrative economies of scale. For example, Rubinfield argues that for the individual and corporate income taxes, tax administration costs will be lower if taxes are collected at the central level than at subnational levels. Collection and enforcement costs for the VAT (especially on a destination basis), customs duties, natural resource taxes, and social security taxes can also be minimized if the central government determines tax policy through legislation, sets uniform regulations, and operates the tax administration. Subnational governments, on the other hand, can collect taxes, such as property taxes, certain excise taxes, and user charges, the administration of which does not present cost advantages associated with the size of government.

Another consideration is the availability of resources, including information, for each level of government. Tax administrations of subnational governments may be less able than the central government to afford the cost of skilled manpower, modern office facilities, and up-to-date technology. However, tax officials at the subnational level have more intimate knowledge of the developments in their geographical area. The knowledge of local conditions is another reason why the property tax is a likely candidate to be administered by local tax officials. As Rubinfield points out, local officials are in a better position than higher-level tax officials to understand the trend of the local real estate market and the effect of zoning and land use regulations on property values.

An argument for the legal framework for some taxes to be set uniformly by the central government is that taxpayers bear an additional cost if they must comply with diverse jurisdictional tax laws. Compliance costs can be especially high for companies that have several branches or subsidiaries operating in different jurisdictional areas. It is not unusual for national corporations in the United States3 to fill out over 15,000 sales tax returns each year (Bialczak, 1989). Tax autonomy for subnational governments can also open the door to excessive tax competition among jurisdictions, which distorts companies’ location decisions, and can involve substantial revenue losses to the competing jurisdictions.

Centralized Tax Administration

Main Features

The option under which all taxes are collected by a central government tax administration provides a minimum amount of administrative complications. In this model, all staff are employed by the central government under one organizational structure. This structure generally encompasses three levels—central, provincial or regional, and local branches of the central tax administration; but there are cases, such as Australia, where the central government tax administration comprises only two levels—the central office and regional branches. In general, all taxes are collected by the central tax administration through their tax offices at the local level, with the regional level playing a supervisory role. This supervisory role includes dealing with taxpayer appeals, collecting the data necessary for an effective management information system, and making sure that the rules and regulations established at the central level are implemented uniformly by the local offices.

Under a centralized tax administration, revenues could be returned to subnational governments through revenue sharing, or transfers, or a combination of both. Revenue-sharing arrangements or assignment of tax bases can take many forms. The simplest arrangement is collection by the central government with sharing determined by a given formula based on some objective criterion, such as origin. A variant of this form is to return a fixed percentage of revenue collected in a given locality back to that locality. However, if an enterprise has factories in many locations but pays all its taxes from its headquarters in a given locality, then that locality may receive more than its fair share, unless some type of formula for apportioning taxes is used.

The major functions of tax administration—taxpayer services, collection, audit, penalties, and appeals—are not affected by the choice between revenue sharing and tax assignment. The revenue-sharing procedures could, however, affect the behavior of the tax staff who may concentrate their efforts on collecting the taxes retained by the central government, at the expense of those shared with the subnational jurisdictions. The choice of a revenue-sharing formula can affect also the motivation and behavior of the tax staff, if tax staff perceive the formula as inequitable. This perception is then reflected in the quality of audits performed, penalties assessed, and appeals reviewed. The formula could also affect the allocation of staff resources (such as highly skilled auditors) if revenues from one tax were primarily distributed to local governments, while revenues from another tax were primarily kept by the central government. It might thus be appropriate to have revenue sharing from a pool of key taxes, including taxes such as VAT, to minimize tax-collection disincentives, rather than to have sharing on a tax-by-tax basis, with varying shares.

With centralized tax administration, it is possible for revenues to be assigned to subnational levels, and for lower levels of government to have legislative control over bases and rate structures. The key issue for lower levels of government is the ability to exercise control over certain tax bases or rates at the “margin.” Problems arise when the central tax administration has to cope with varying definitions of the base and different rates of tax—although there are possibilities of “harmonization.” However, more complications generally are created when taxpayers have to comply with more than one set of tax rules.

This model of tax administration is, not surprisingly, much more common in unitary countries than in federal countries. The tax administrations of Italy, France, Portugal, many countries in French-speaking West Africa, many formerly socialist countries, and certain Latin American countries fit into this model of centralized tax administration.

Advantages and Disadvantages

Under one organizational structure for all tax administration, clear lines of authority are drawn so that tax staff in local offices realize that they are required to follow the rules and regulations established at the central level. Thus, taxes are collected throughout the country following the same process and procedures. This, inter alia, makes it easier for the tax administration to set up a simple computer system to monitor the collection of various taxes. Taxpayers’ records with respect to each type of tax can be consolidated into one database or master file. Stop-filers can be detected quickly, and delinquent accounts can be addressed in an organized fashion. Taxpayers are more likely to receive uniform treatment in assessment, audit, penalties, and appeals, irrespective of where they reside. A well-publicized emphasis on uniform treatment enhances the perception of fairness of the tax system. Enforcement, especially the audit component of enforcement, is simplified if the tax inspector has information, from the taxpayer master file, on every tax for which a given taxpayer is liable. Also, there is no need to establish exchange of information agreements among tax administrations of different governmental units.

The price for this administrative simplicity is that local governments may perceive that they have very little control over receipts. In fact, however, subnational government control over revenues at the margin is more a function of controlling the marginal tax rates than administration per se. Thus, the perception of loss of control with central administration may reflect the balance of political powers between “potentially antagonist” governments, rather than technical constraints.

The assignment of revenues collected by a central tax administration may, however, face a number of difficulties. This is, for instance, the case if the personal income tax is assigned to local governments. Some formerly socialist countries, including most in the former Soviet Union, have decided to assign personal income tax revenue to local jurisdictions (Bell and Regulska, 1992). The problem, in this case, is that income taxes can be levied in principle by the jurisdiction where the income was obtained (source) or the jurisdiction where the taxpayer resides (residency). Assuming that the jurisdiction of residence is entitled to the taxes, the tax administration will have to verify residency. If person X lives in locality A, then all of X’s income tax must be transferred from the central government’s account to local government A’s account. If person X lives in one locality and works in another, say locality B, then either the employer or the tax administration will have to verify that withholding taxes paid by the employer are allocated to the correct account. If, on the other hand, all of the personal income taxes withheld by the employer in locality B go to the local government of locality B, then administrative problems are somewhat reduced. However, if person X also receives income from other sources, such as renting out part of his residence in locality A, tax administration is complicated because person X would presumably fill out a tax return and make payment in locality A. The issue of withheld interest income also poses problems for tax administration if the tax department has to verify the residency of each taxpayer each time interest is paid. If each locality can set its own tax rates, compliance problems for withholders and verification problems for tax officials are further complicated, especially if localities often change these rates.

Piggybacking of a tax by a lower level government on a federal tax base can be one solution to these difficulties, as in Canada. In Canada, with the exception of Quebec, personal income taxes are levied by both the federal and provincial governments, but collected by the federal government. Taxpayers file one unified (federal and provincial) tax return and calculate their provincial tax as a percentage of their federal tax (tax on tax). The percentage may vary depending on the taxpayer’s province, because each province has the authority to set its own tax rate.4 If a taxpayer has moved during the year, the province of residence on December 31 receives the tax revenue for the whole year. The federal government pays an estimated amount to the provinces during the year and calculates a final reconciliation after all tax returns are received.

Multilevel Government Tax Administration

Main Features

When a country authorizes one governmental level other than the center, or various levels of government, to levy and collect taxes, administration becomes more complicated than in the case of centralized tax administration. In general, each level of tax administration can create its own organizational structure and processes, which may not be the most efficient from a countrywide perspective. Duplication of effort among levels can easily occur, and effectiveness can suffer if the various tax administrations do not put in place requirements for adequate coordination. While local government officials may have increased autonomy, freedom, and resources to pursue local policy objectives, taxpayers are likely to bear higher compliance costs as each level of tax administration issues different forms, regulations, and procedures.

Under the approach where multiple levels of government are responsible for collecting taxes, the choice between revenue sharing and tax assignment may affect certain functions of tax administration. Normally, revenues are shared downward from central government to subnational governments. However, in a few countries revenue may be shared upward, and subnational governments are authorized to collect all taxes.5 In this case, certain safeguards are necessary (for example, comprehensive and uniform training of tax officials, strict adherence to audit guidelines) to prevent nonuniform application of the tax laws. If taxes are assigned so that each level of government has authority to legislate and collect its own set of taxes, then problems of coordination among tax administrations are likely, and taxpayer compliance cost may be higher than under other options. Federations such as the United States, Switzerland, and Brazil are examples of countries with multilevel tax administrations and tax assignment (with some control over revenue, administration, and legislation).

Advantages and Disadvantages

Subnational tax administration provides more flexibility with respect to organizational structure and personnel practices than a centralized one. Local officials become more accountable, as a clearer link is established between local decisions to raise revenues and to make expenditures. One disadvantage of this system is that some subnational governments, owing to resource constraints, may not be able to staff the various tax administration functions adequately. If some of these governments allocate fewer resources to areas such as taxpayer services, audit, penalties, and appeals, then it is possible that taxpayers in different jurisdictions would not receive uniform treatment with respect to all tax administration functions.

In situations where a jurisdiction surrenders a large net amount of tax revenue to the center, perverse incentives can be created to maintain revenue in the jurisdiction by favorable assessment of taxes due. In pre-1994 China, for example, the central government relied on the local (provincial) tax administration to collect most taxes.6 Revenue was then shared between the provinces and the center on the basis of an ad hoc revenue-sharing formula, negotiated separately for each province.7 The temptation was strong to lower the official assessment and then split the difference between the local government and the taxpayer. While the central government officials were aware of this problem, they were unable, with a staff of about 450, to police effectively the activities of more than 500,000 tax staff at the local (provincial) level. Tax administration in China became rule by negotiation rather than rule by law. Changes in tax policy may not be implemented as intended if tax collection becomes a process of negotiation. In order to move closer to rule by law, the Chinese tax structure was overhauled in 1994, with uniform tax laws, a central tax administration for central and shared taxes, as well as parallel provincial or local tax administrations, to remove the perverse incentives from the system.

In some countries, each level of government has tax policy and administration powers over the same tax bases, as in the United States, Switzerland, and Brazil. This arrangement maximizes state or local autonomy and is generally found where states (or provinces) are sovereign bodies. Autonomy is restricted, however, if a higher level of government defines the tax base and rates, or places boundaries on the tax base and/or rates. For further details on tax administration in these countries see below.

If taxpayers must deal with several different tax authorities, tax administration can be complicated by duplication of effort among the various tax authorities. Hence, coordination among various tax departments becomes crucial, especially in the area of audits. As part of the federal income tax law in the United States, tax returns and tax return information can generally be disclosed to state tax agencies. If a taxpayer in the United States is audited with respect to federal income taxes, any action taken that changes the taxpayer’s liability is automatically transmitted to state tax authorities. States that find state income tax violations also share that information with the Internal Revenue Service (IRS). There is a formal information-sharing agreement between states and the IRS. Detailed guidelines have been published to ensure confidentiality of taxpayer information (United States, Internal Revenue Service, 1993). On the other hand, state tax agencies in Brazil do not share information with Brazil’s central government tax agency.

Thus, overall tax administration in Brazil is rendered less effective because it becomes more difficult to foster voluntary compliance by ensuring, as much as possible, that taxpayers face a reasonable risk of detection if they do not comply.

Table 1 presents a summary of the advantages and disadvantages under centralized and multilevel tax administration.

Table 1.Summary of Tax Administration Advantages and Disadvantages
Central Government Tax Administration
AdvantagesDisadvantages
  • One organization
  • Clear lines of authority
  • Same processes and procedures
  • Uniform rules and regulations
  • One computer system, with one taxpayer record for all taxes
  • No need to exchange information
  • Stopfilers and delinquent accounts detectable more quickly
  • Uniform treatment in assessment, audit, penalties, and appeals
  • Simplifies auditing all taxes of a given taxpayer
  • Same training and same manuals
  • Perception of less local control over revenues, especially if accompanied by central government control over rate structure
Multilevel Government Tax Administration
AdvantagesDisadvantages
  • More responsibility of local tax administrators for revenue performance
  • More flexibility for local tax administrators
  • May be more appropriate for certain types of tax (e.g., property taxes)
  • May reflect political/constitutional constraints
  • More freedom for local policymakers to follow local preferences, if effective administration is feasible
  • National policies (including stabilization) may not be implemented correctly
  • May be more appropriate for certain types of tax (e.g., property taxes) • Duplication of effort possible, ii more than one administration is used for a single tax base
  • Potential for nonuniform treatment of taxpayers
  • Various tax administration functions may not be staffed adequately
  • Effectiveness may suffer if the various tax administrations do not coordinate among themselves
  • Taxpayer compliance costs are relatively high

Comparisons for Selected Countries

Are there obvious reasons why some countries centralize tax administration, while other countries choose some form of decentralized tax administration? Table 2 shows, for selected countries, the level of government primarily responsible for collecting at least one major tax. Countries in which administration is centralized are more likely to be unitary ones. Many countries with two or three levels of government authorized to collect taxes are federations. Three levels of tax administration are more prevalent in the largest countries. Although the federative or unitary nature of a country and its size appear to be important factors in determining the choice of the model of tax administration, other factors, such as historical trends and the balance of power among government levels, are also likely to play a role in this choice.

Table 2.Selected Countries: Government Responsible for Collecting at Least One Major Tax
CentralState, Provincial, or RegionalMunicipal or Local
Algeria
Belgium
Bulgaria
Chile
China (pre-1994)
Côte d’Ivoire
Estonia
France
Guatemala
Iran, Islamic Rep. of
Malawi
Norway
Poland
Portugal
Romania
Sweden
Germany
Netherlands
Paraguay
Switzerland
United Kingdom
Argentina
Australia
Brazil
Canada
Colombia
India
United States
Sources: Information provided by various tax officials and IMF staff; and Bird (1986).Note: Major taxes include income, sales, VAT, excises, customs, natural resource, and property. In some countries, local governments collect minor taxes, license taxes, and fees, which are not captured in this table.
Sources: Information provided by various tax officials and IMF staff; and Bird (1986).Note: Major taxes include income, sales, VAT, excises, customs, natural resource, and property. In some countries, local governments collect minor taxes, license taxes, and fees, which are not captured in this table.

The specific circumstances of each country also determine how tax revenue is allocated among the levels. Table 3 illustrates the percentage of tax revenue attributable to (not collected by) each level of government for three specific taxes—income, property, and consumption—and for total tax revenue. Central governments, with the exception of some Scandinavian countries, generally receive most of the revenue from income taxes. Similarly, central governments generally receive most of the revenue from consumption taxes, with the exceptions of Brazil, India, and the United States. Local governments (and a few state governments) generally receive most of the revenue from property taxes, with the exceptions of some European countries and Chile.

Table 3.Tax Revenue Attributable to Each Level of Government(In percent of general government)
Total Tax RevenueTaxes on IncomeTaxes on PropertyDomestic Taxes on Goods and Services
Country and YearCSLCSLCSLCSL
Netherlands (1988)97.80.8100.0100.099.4
Paraguay (1987)97.62.4
Indonesia (1988)97.32.7100.055.444.695.44.6
Chile (1987)96.53.5100.0100.095.54.5
Kenya (1986)96.43.6100.01.498.697.62.4
Zimbabwe (1986)96.33.7100.012.387.798.31.7
Ireland (1987)96.02.3100.042.957.198.7
Malawi (1984)95.94.199.70.31.998.199.80.2
Israel (1986)95.54.5100.022.977.1100.0
Thailand (1988)95.05.0100.058.841.292.87.2
South Africa (1986)94.41.54.1100.027.772.395.64.4
Belgium (1987)93.55.090.010.0100.095.93.3
New Zealand (1981)93.56.5100.017.982.198.81.2
Luxembourg (1987)93.36.287.612.492.08.099.20.7
Hungary (1988)91.78.873.226.855.545.599.20.8
France (1988)90.09.2
United Kingdom (1987)88.110.7100.017.083.099.8
Spain (1986)87.73.39.084.31.214.456.723.919.476.17.416.5
Mexico (1984)84.612.72.798.21.60.28.752.438.999.40.30.3
Australia (1987)81.11533.6100.04.949.246.075.624.4
Norway (1986)80.919.157.142.940.659.499.80.2
Poland (1988)80.919.179.620.450.849.289.210.8
Colombia (1984)80.313.36.3100.09.590.570.030.0
Bolivia (1986)78.618.43.099.20.860.136.23.7
Sweden (1987)77.732.633.266.8100.0100.0
Pakistan (1979)76.918.54.6
Finland (1987)76.025.3
Austria (1987)75.811.512.758.022.619.452.14.343.671.513.115.6
Brazil (1987)71.426.61.9100.02.851.945.343.753.42.8
Denmark (1987)71.228.254.043.057.043.09940.1
Germany (1988)69.821.77.639.440.520.15.254.540.369.929.40.1
India (1986)67.232.8100.039.061.051.948.1
United States (1987)66.720.612.881.616.81.75.67.287.117.168.014.9
Switzerland (1987)60.522.816.722.842.235.032.642.225.287.711.80.5
Canada (1988)50.840.09.263.536.516.183.938.760.80.5
Source: Levin (1991).Note: C = central government, S = state government, and L = local government; figures are the average of latest three years available.
Source: Levin (1991).Note: C = central government, S = state government, and L = local government; figures are the average of latest three years available.

Developed Countries

Germany

Germany employs an extensive revenue-sharing system, characterized by some as the dominant feature of their federalism (Bird, 1986). Taxes are primarily administered at the state (Länder) level (with the exception of border taxes), but tax policy is harmonized (Spahn, Steinmetz, and Föttinger, 1996). Tax laws are passed at the federal (Bund) level, but state interests are carefully considered because of the unique role played by the Bundesrat (upper house or federal council). Members of the Bundesrat are directly appointed by state governments and vote to protect the interest of their state rather than a political party.

Administration is implemented on a uniform basis, following rule by law. The German administrative system is highly integrated and coordinated. Federal tax officials, in cooperation with state tax officials, determine tax administration processes and procedures. Since some discrepancies in administration are bound to appear, German tax administrators meet on a periodic basis to harmonize implementation of the tax laws. All tax staff are trained to follow agreed upon processes and procedures, to ensure uniformity in treatment of taxpayers. The German Länder also have information-sharing agreements if a business pays taxes in more than one Land. However, this information may have to be transmitted in hard copy because the Länder do not utilize the same computer systems.

Switzerland

Swiss taxpayers strongly believe that the preferences of each canton have a high priority (Bird, 1986). They are willing to bear the burden of extra compliance costs to ensure that local officials have the necessary own source revenues to meet the demand for local public goods. The canton’s taxing powers are relatively broad, within certain constitutional restrictions. For example, double taxation, special taxes on any trade or industry, and unjustified tax relief are prohibited.8 Jurisdictions within cantons can also levy taxes and set rates, with authorization from the canton.

The tax administrations of the cantons collect income tax for both the canton and the confederation. While taxpayers only need to file one tax return covering both taxes, the definition of taxable income will normally differ between the canton and the confederation because each canton is free to determine levels of exemptions or deductions. So the taxpayer must make two calculations of taxable income, and the tax administration must verify that both calculations are correct. Also, tax auditors must be careful not to confuse the tax rules for cantons with the tax rules for the confederation. While encouragement of diversity is the accepted practice in Switzerland, it does complicate tax administration.

United States

In the United States, the various tax administrations use different methods to collect delinquent taxes. In addition to the traditional method of personal contact by field collection staff, state tax administrations have adopted methods such as (1) new or improved accounts receivable management information systems, (2) updated written billing procedures, (3) telephone collection techniques, and (4) enforcement programs that restrict business taxpayer access to certain state licenses and permits if delinquent taxes are not resolved. Some states have modified the roles of revenue officers by reducing the level of personal contact in favor of the above methods. Many states are using modern collection methods not currently used by the IRS. These states have employed private collection companies to collect unpaid taxes and have allowed delinquent taxpayers to use credit cards in paying the taxes due (United States, General Accounting Office, 1994).

Taxpayer compliance costs can be higher with multiple tax administrations than under other options. Currently, 43 states in the United States plus the District of Columbia have adopted a personal income tax.9 As a result, U.S. taxpayers must file two tax returns, calculating taxable income and tax liability twice, because tax rates, deductions, and exemptions differ between the central level and the state level.10

Developing Countries

India

In contrast to tax sharing upward in pre-1994 China and Germany, India is one of a number of countries with multilevel government tax administration, where tax revenue is shared downward. However, the system in India, which provides for revenue sharing on a tax-by-tax basis, also contains some perverse incentives that can reduce the effectiveness of tax administration. For example, central government tax officials collect all individual income taxes on nonagricultural income and then return 85 percent of revenue collected to the states. Even though the tax administration is given a collection target in the budget, the incentive to allocate sufficient enforcement resources and perform high-quality audits for this tax is lower than other taxes, for example, the profit tax or customs duties, where revenue is retained by the central government.

Brazil

In Brazil, the central government levies a VAT on industrial products (IPI), while the states levy a VAT on a broad range of products (ICMS) (Rodriguez, 1990, and Chapter 18). Both taxes have multiple rates, but the state tax rates cannot exceed a ceiling fixed by the Senate. A committee composed of the financial secretaries of each state (CONFAZ) is responsible for coordination of the VAT, including authorization of exemptions. With respect to interstate transactions, the origin principle is generally applied. The exporting state levies the tax on exports, and the importing state allows a credit to importers, for the tax paid to the exporting state. The distribution of VAT revenue across states depends heavily on the balance of trade with other states.

Tax administration in Brazil is complicated for various reasons. There is an inevitable duplication of effort between the federal and the state governments in the taxation of similar bases under the two VAT-type taxes. Taxpayers must have two taxpayer identification numbers—one for the federal VAT and one for the state VAT—and file two sets of tax returns. The tax administration must also follow two different sets of procedures for invoices of goods shipped between states and goods shipped within a state. Since there is no central statistical database to record sales and purchases for the state VAT, it is impossible to conduct a systematic cross-checking of information. Thus, state auditors are placed in a relatively weak position by a lack of important information. Of course these significant tax administration drawbacks have to be weighed against the gains in increased autonomy for the states.

Countries in Transition

In former socialist countries where tax administrations are still relatively weak, it is essential that adequate resources be allocated to the major functions of collection and audit. These functions were relatively simple to perform with respect to large state-owned enterprises, whose resources, including bank accounts, were closely controlled by their ministries. With a greater market orientation, government control over enterprises still under public ownership is being eroded, and tax administration is even weaker with respect to privatized enterprises or new businesses. Also, for individuals under the socialist system, the tax burden was hidden (the difference between their purchasing power and shadow value of their contribution to production); now the tax burden is explicit, requiring the tax administration to strengthen the audit and collection functions (Ickes and Slemrod, 1992).

The picture is further complicated by the uncertainty surrounding intergovernmental relations in these countries. Both expenditure and tax assignments, as well as the systems of intergovernmental transfers, remain in a state of flux in many formerly centrally planned economies.

Moreover, some of these countries have assigned revenue by ownership rights, rather than by tax. If a local government owns an enterprise, it is entitled to the revenues generated by that enterprise, while a similar enterprise owned by the central government would pay its taxes to the latter. The capacity to enforce taxes on locally owned enterprises is wanting in many instances.

Even though subnational governments are clamoring for autonomy, it makes sense to keep tax administration simple, at least during the transition. A distinction should be drawn between what is technically feasible in the short term and what is a goal to strive for in the long term. In the short term, the most feasible approach may be to establish only one tax administration at the central government level with some type of revenue sharing based on an objective formula.

Issues in Moving from Centralized to Multilevel Tax Administration

General Considerations

Given the trend toward decentralization of expenditures and concomitant financing apparent around the world, steps should be taken to ensure effective tax administration at all levels of government. The first step is to take clear decisions regarding the taxes to be assigned to subnational governments. The knowledge, skills, and abilities needed to administer a property tax, for example, differ from those needed to administer a personal income tax, and the former may be easier to devolve and administer at lower levels of government than the latter. Several key elements should be put in place to establish subnational tax administrations with adequate capacity to collect the devolved taxes. These elements of any successful tax administration reform include a well-defined strategy, a sustained political commitment, a dedicated implementation team, the necessary physical resources, and the provision of appropriate training (Tanzi and Pellechio, 1997).

Subnational tax administrations would have to recruit and train staff to perform various functions within an appropriate organizational structure.11 The organization should include several basic tax administration functions. One unit should be established to provide taxpayer services (education, information, assistance). Simple collection procedures should be designed to minimize the burden on taxpayers. These procedures could be manual at first, but they should be designed with a view to computerizing taxpayer records as soon as possible.12 Depending on the type of tax administered, a unit of auditors or land assessors should be established and staff should be trained. Finally, a straightforward system of penalties and appeals should be developed. A separate unit should be responsible for each of these functions (Casanegra de Jantscher, Silvani, and Vehorn, 1992).

In addition to an organizational plan, other preparatory steps should be undertaken. For example, discussions should be held with the central tax administration to provide for some type of information sharing, so that cross-checking activities can be performed. Also, it would be appropriate to form a group of subnational tax administrators, who could meet regularly to discuss common problems and solutions. This group, for instance, could prepare a model tax declaration so that each administration does not have to design its own form. It could also disseminate information on various issues, such as how to strengthen enforcement. State tax administrations in the United States have formed the Federation of Tax Administrators, which performs a number of coordinating and information-disseminating activities.

Administering Subnational Taxes

In this subsection, the type of tax administration choices that would typically face a lower level government is illustrated. Not all possible subnational tax assignments are addressed (for this, see Chapter 3) but the focus is on a key subgroup to show the main choices for some taxes used by lower levels of government in many countries: property taxes, business licenses and user charges, surcharges on the income tax, as well as indirect taxes including excises, the VAT, and the retail sales tax.

Property Taxes

As discussed earlier, property taxes are the prime example of revenues that should be assigned to lower levels of government, particularly to the municipal or local levels. Indeed, the information needed to administer this tax differs substantially from that which would be required say for other direct taxes, such as the corporate or personal income taxes, or for indirect taxes, such as the VAT or sales taxes. The focus of a property tax administration is to generate a register of property titles, as well as valuations that are reasonably up to date. Thus, even if there were a single tax administration for all taxes, it is likely that property taxes would be collected separately, for example, from the VAT.

In many developing countries, the greatest difficulty in administering a property tax is to generate comparable and recent information on the property stock, ownership, and valuation. In countries such as Colombia, the maintenance of the property register and updating the valuation is centrally coordinated, although the billing, filing of payments, and auditing of the property tax are carried out at the local level. However, even the centrally maintained property register can prove to be cumbersome and difficult to update in a rapidly changing environment of property development and escalating values, as has been the case in Colombia.

An alternative to the traditional method of property administration based solely on the property register is also to permit self-assessments. Such a method relies on the principles of tax administration enunciated earlier—taxpayer compliance and evaluation, auditing procedures, and penalties and appeals. This method has been applied, for instance, in the Colombian capital, Bogotá, and is seen as a way of circumventing the time-consuming process of updating the property register. Two essential elements with this variant include (1) the collection of information on property sales by the local administration, such as the requirement to register a sale before titles can be transferred; and (2) a visibly unbiased enforcement of sanctions. An example of such a sanction is that the local authority has the right to purchase a property at say between 1 and 1.5 times the declared valuation, in cases where underdeclaration is suspected. Bogotá has had a rapid increase in property tax collections in the two years since the self-valuation scheme was introduced. However, it is important not to come to quick generalizations in this context, since the success of such a method of self-declaration depends crucially on an effective and fair tax administration, with the political will to implement sanctions (without which the scheme could quickly degenerate into revenue loss). To prevent revenue loss, a hybrid administration is also possible, with the traditional property register being maintained as a floor to the property tax liabilities, together with self-declaration based on market values. As has been demonstrated in Bogota, it is possible to improve property tax collection rapidly by applying tax administration principles judiciously. Bogota’s success would not have been possible if sole reliance had been placed on a property register, which was already better and more sophisticated than those available in most developing countries.

Licenses, Presumptive Taxes, and User Fees

The utilization of local information permits the effective local administration of licenses and other presumptive taxes on small businesses and informal sector activities. Such sectors are of great importance in developing and transition economies and are relatively hard to tax given the main tax instruments, such as the income tax or the VAT. The obvious danger with presumptive taxation is the possibility of arbitrariness on the part of the tax administration that could generate more corruption and nuisance than revenues. The various alternatives in this regard seek to minimize discretion on part of the tax administrators and protect the rights of taxpayers, while preserving the revenue base. Some of these options are discussed below.

Standard assessments are one method of imposing presumptive taxes. These are lump sum and could be made a function of occupation or business activity. The lump-sum nature of the tax has positive incentive effects on production. The criteria for imposition of the tax should be clearly defined, and little discretion be given to tax administrators, to minimize corruption. While lump-sum presumptive taxes or licenses are easy to administer, and have positive incentive effects, they generally cannot be easily adjusted for inflation or allow for specific circumstances of taxpayers, and for these reasons may have a limited revenue potential. It is possible also to have estimated assessments, which are based on indicators such as the size of business premises, number of employees, installed machinery, electricity use, and so on. In countries such as Italy, coefficients have been developed for particular activities. Procedural aspects have been clearly defined, permitting taxpayers to challenge the applicability of the coefficients, specifying the time period and documentation required (Mercurio, 1994). In countries with local tax administration, there may be some advantage in determining the presumptive base (or coefficients) on a systematic basis (at the regional or perhaps even national level, given the institutional and constitutional arrangements), in order to avoid “nuisance” levies. There is clearly a trade-off between the extent to which the lump-sum nature of the taxes is to be modified, and the discretion available to the tax collectors. Thus, the need to allow taxpayer appeals and ensure rapid and fair adjudication of disputed claims becomes important if taxpayer compliance is to be maintained.

User fees are normally implemented by public service providers and do not generally put pressure on local tax administration resources.

Piggybacked Taxes or Surcharges

The essence of responsible decision making by lower levels of government is the ability to raise own tax rates at the margin to meet additional expenditures. A local tax administration without the ability to influence marginal tax rates does not meet this criterion, but may still be used in cases in which there is distrust of the national tax administration by the lower levels of government. For some mobile tax bases, a simple alternative to an elaborate subnational tax administration is to piggyback on a national tax base, such as the personal income tax. A possible option is a surcharge imposed by the lower level of government on the amount of federal income tax liability. With this form of piggybacking, the distribution of provincial tax revenues would parallel the tax-sharing outcomes. Another option is for the tax to be levied directly on the federal tax base, to avoid tax-on-tax pyramiding. With either variant, the tax would not involve additional tax forms, and the taxpayer would be required simply to fill in an additional line on the federal tax form, permitting the funds to be credited directly by the banks to separate federal and provincial accounts. Lower levels of government could be given the authority to set the rate of the supplementary flat tax or surcharge, subject to a limit (and/or floor), in order to achieve the control over marginal tax rates necessary for local government accountability. Where lower-level auditing capabilities are weak, the central government could perform this function for lower levels of government. However, if there is mistrust of the federal government, separate auditing capabilities could be developed at the lower level, although as argued above, there would be significant benefits from the sharing of information.

For administratively feasible piggybacking by the lower levels of government, the importance of maintaining the same subnational tax base as at the central level cannot be overemphasized. As the Canadian experience suggests, a simple tax can become extremely complicated as lower levels of government indulge in granting various exemptions, thus effectively changing the relevant tax base for piggybacking.

In practice, the federal government would have to inform the subnational governments of the expected tax base, including all federal tax deductions, well in advance of the budget preparation cycle of the provinces or local governments. The subnational levels of government would have to determine their tax rates at about this stage, to allow sufficient time for the central tax administration to inform employers about the local tax rates applying to employees residing in different local or provincial tax jurisdictions. Thus, a single withholding would apply to each taxpayer, to be distributed among different levels of government.

State or Provincial Indirect Taxes

While subnational VATs are feasible, they result in a great deal of administrative complexity if the objective of the subnational government is to tax final consumption, as with the destination-basis VATs. Much of the complexity lies in the treatment of interprovincial sales and zero rating of exports to other provinces under the destination basis. An origin-basis VAT is much simpler to administer: sales to other provinces are taxed, and imports are not. However, in the absence of an interprovincial redistribution mechanism, this system would clearly benefit those provinces where much of the production and refining base is located. Moreover, differences in rates of an origin-basis VAT can promote distortions in location, production, and pricing decisions of national enterprises.

Certain types of excises may also prove difficult to administer at the subnational level. In principle, if an excise is treated as a tax on a final consumer good levied at the point of production, for example, the refinery or the brewery, there should be little difficulty for the provincial or even the local administration in collecting the tax. Usually such production points are few and located in only some of the provinces. There is thus a possibility of increasing horizontal fiscal disparities with such a tax assignment. However, if the tax is levied at the point of consumption, local administration becomes problematic, particularly regarding sales to other provinces. Monitoring sales becomes difficult, and a problem of “domestic contraband” may develop for excisable goods, as in Colombia for example for alcoholic drinks.

A retail sales tax at the subnational level is more feasible than a subnational VAT and, if exemptions are kept to a minimum, provides broader coverage than excise taxes. The United States is one example of a federal system where states depend heavily on the retail sales tax.13 The heavy reliance is due in part to (1) the relatively limited resistance toward the retail sales tax in comparison with the two major alternatives—the state income tax or the property tax; (2) the belief that the sales tax produces a more stable revenue flow and fewer distortions than the income tax; and (3) the belief that the retail sales tax is relatively easy to administer. The fact that the federal government does not rely on the retail sales tax also encourages states to rely on this tax as a major revenue source. The two major drawbacks of the sales tax are the problem of regressivity and the problem in taxing interstate transactions. Regressivity can be reduced through exemptions or credits, but tax administrators claim that exemptions or credits increase the burden of administration by complicating audits as the tax is often misapplied. Interstate sales will continue to be a problem since states do not have the authority to require out-of-state vendors to collect and remit the sales tax (Due and Mikesell, 1994).

Conclusions

The design of the subnational taxes may have repercussions on tax administration and, conversely, tax policy options and assignments are constrained by tax administration capabilities at each level of government. Thus, there is little benefit for subnational governments in taking on tax tools that they are unable to administer, or others where the ability to influence the marginal tax rates is limited. However, in many parts of the world the search continues for “appropriate” and easily administered subnational revenue sources to match the increasing devolution of expenditure responsibilities to lower levels of government.

Administrative complexity increases when subnational governments attempt to levy and collect taxes on mobile tax bases. This is particularly noticeable in the case of indirect taxes such as the VAT and income taxes. One level of tax administration is to be recommended in such cases (this may be at the provincial level in countries with adequate administrations, such as for the VAT in Germany and Quebec, with central government revenues or shares distributed upward). The more typical case is of a VAT administered by the center, with revenues shared with provinces on a derivation or formula basis. Equalization of revenue or fiscal capacities would come through an explicit grants mechanism or the revenue-sharing formula adopted. Administration can be simplified and, at the same time, provincial control over marginal tax rates can be achieved if piggybacking on a central tax administration and a harmonized tax base (for example, income) is used.

The trade-off between administrative ease and local autonomy has created many different ways in which tax administration is organized. As this chapter has described, some countries rely purely on central government administration; other countries rely on tax administration at lower levels or all levels of government. For subnational tax administration to be effective all the major functions of tax administration (taxpayer services, collection, audit, penalties, and appeals) should be provided. Also, provision should be made for the sharing of information across different levels of tax administration because of the significant efficiency gains that can be achieved. Some functions, for example, certain collection activities, may be contracted out to higher levels of government or the private sector by those subnational governments that lack the capability to provide the function on their own.

Several countries tend to have separate administrations for clearly lower-level tax bases, including, inter alia, property taxes, as well as small businesses and service sector activities. The former is an illustration of an immobile tax base, although problems may exist with the registration of property and its valuation. The latter would be governed by the existence of local information and knowledge that may not be available to higher levels of administration. In such cases, there is a trade-off between simple lump-sum taxes that might have limited revenue potential and more complex formulations that allow some discretion to tax administrators. The choice in most cases is to minimize the discretion to the tax collectors, while raising revenues in as fair a manner as possible. The outcomes vary across countries, reflecting different institutions, administrative capabilities, and political-economy constraints.

Most developing countries and countries in transition to a market economy are likely to face serious complications if they do not place a high priority on the criterion of administrative ease and simplicity of tax design. Many of these countries have not fully developed the institutional capability to successfully operate separate and independent tax administrations at various levels of government (Rice, 1992). This is likely to prove to be a serious bottleneck to responsible governance as expenditure functions continue to be decentralized.

With assistance from Kazutomi Kurihara. The authors would like to thank Teresa Ter-Minassian, Milka Casaneyra de Jantscher, Carlos Silvani, Parthasarathi Shome, and Tony Pellechio for helpful comments on earlier drafts of the chapter.
1In practice, these four models are not mutually exclusive, so some countries may not fit easily into one category. For example, a country may combine revenue sharing and tax assignment to reach a desired allocation of revenue. However, these conceptual models allow for a more focused evaluation of the tax administration issues. McLure (1983) discusses similar conceptual models to assign the corporate income tax to various levels of government, but does not present a detailed discussion of the administrative dimension.
2In the tax administration literature, a distinction is made between efficiency—minimizing cost of collection, and effectiveness—promotion of voluntary compliance.
3In the United States, the retail sales tax is primarily the domain of state governments, which have the legal authority to establish their own tax rate or rates and tax base (see Chapter 15).
4A basically simple system has become excessively complicated as provinces sought more autonomy to respond to voters who demand that local politicians do something to alleviate various perceived problems. Recently, provinces have enacted certain tax credits that have been administered by the central tax administration. Especially controversial are certain proposals that advocates call “province-building” investment credits, which opponents consider beggar-my-neighbor investment provisions (Hartle, 1993). These provisions would move the administratively simple “tax-on-tax” system to a more complicated “tax-on-income” system.
5Pre-1994 China and Germany are examples of this option. China, as discussed below, is undergoing comprehensive tax administration reform to create a central tax administration, in parallel with provincial tax collection agencies.
6This reliance created divided loyalties because tax staff, in effect, had to serve two masters—the central government and the provincial or local government. The central tax administration expected each jurisdictional tax administration to follow national tax administration policies, but there were few incentives to ensure that national policies were implemented correctly when the lower-level governments paid the salaries of tax administrators.
7Some minor taxes that brought in a relatively small amount of revenue were assigned to local governments.
8The Constitution allows cantons full authority to levy any tax not expressly reserved for the confederation and sets restrictions on the rates of taxes collected by the confederation.
9For further discussion of the U.S. system, see Chapter 15 below.
10Three states define state tax liability as a percentage of federal tax liability. Twenty-five states, plus the District of Columbia, use federal adjusted gross income as the starting tax base for taxpayers to calculate their state income taxes; eight states use federal taxable income as the starting base; two states tax only interest and dividend income; and five states use income tax bases that are not related to the federal income tax base (Erard and Vaillancourt, 1993).
11In principle, staff should be trained in tax law, the relevant procedural and administrative law, investigative methods, computer technology, economics, and management (Bagchi, Bird, and Das-Gupta, 1995).
12If possible, subnational tax administrations should use for each taxpayer the same taxpayer identification number as used by the central tax administration.
13Forty-five states plus the District of Columbia utilize the retail sales tax with statutory rates varying from 3 percent to 8 percent (Ebel and Zimmerman, 1992).
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