What Do We Know about the Impact of Tax Reforms on Private Sector Development?

I recently conducted a literature review on the impact of tax reforms on private sector development as part of the Investment Climate Impact Project.¹ My goal was to take stock of what is currently known about the impact of reforms that the World Bank is supporting in this area and to identify the gaps in knowledge that we ought to fill by conducting more impact evaluations. While tax reforms can have a broad range of effects in the economy, the focus here was on private sector outcomes only, as measured by investment, tax evasion by formal firms, formal firm creation, and firms’ economic performance.

It turns out that most papers in this area study the impact of changing tax rates. Both cross-country and micro-level  studies suggest that lowering tax rates can increase investment, reduce tax evasion, promote formal firm creation and ultimately lead to an increase in firms’ sales and GDP growth overall. However, lowering tax rates also has important implications for government revenue and it is thus often difficult to balance the trade-offs between various goals of public policy.

Another, perhaps less controversial, aspect of tax reform has recently gained more and more attention: lowering the regulatory burden associated with paying taxes. The World Bank’s Doing Business initiative measures the number of payments and days it takes firms to pay taxes in 183 economies and suggests that these numbers are quite high in many economies. For example, in one quarter of the sample, firms need to make than 40 separate tax payments a year. Also, in one quarter of the sample, the time it takes to pay taxes is greater than 325 hours (8 weeks!). In fact, the World Bank’s Enterprise Surveys show that a large fraction of formal firms, particularly in the Latin America and Caribbean and the Middle East and North Africa regions, identify tax administration as a major obstacle.

Source: Author’s calculations based on data from World Bank Enterprise Surveys in 2005–10.
Note: Data cover 128 countries and are the latest available for each country.

Currently, the number of studies that examine the impact of lowering the regulatory tax burden is small. Djankov et al (2010) find no correlation between investment and number of hours needed to pay taxes (or number of payments) across countries. They do find that a 10 percent decrease in number of tax payments is associated with an increase in the number of formal firms by 1.6 per 100 people of working age. Since this is a cross-country study, the results are not necessarily causal, though, and could be driven by other factors that vary across countries and that are hard to control for in the analysis.

I am only aware of one rigorous within-country study that investigates the impact of a reform that simplified tax regulation. This paper, Fajnzylber, Maloney, and Montes-Rojas (forthcoming), shows that the introduction of the “SIMPLES” tax regime in Brazil increased the share of micro firms that are registered with the tax authorities by 7.2 percentage points (from only 13 percent before the reform to 20.2 percent after the reform). The authors also find that the SIMPLES increased firms’ sales by 37 percent. While SIMPLES consolidated six separate federal tax and social security payments into a single monthly Payment, thus lowering the regulatory burden of taxes, it also reduced the tax rate by up to 8 percent of annual revenue for both micro and small firms. It is therefore not clear to what extent we can attribute the measured effect to simplifying regulation vs. lowering tax rates.

In conclusion, we need more within-country studies that can shed light on the effects of simplifying tax regulation on formal firm creation, investment, tax evasion in formal firms, and sales. To start addressing this need, as part of the Investment Climate Impact Project, we are currently working on an impact evaluation of a small and medium enterprise tax reform in Georgia. This reform is very recent and any potential effects will take some time to materialize, but we will keep All About Finance readers posted as the results come in…

Further Reading:

Bruhn, Miriam. 2011. “What Is the Effect on Private Sector Development? What Is the Effect on Private Sector Development?” World Bank Viewpoint Public Policy for the Private Sector Note Number 330.

Djankov, Simeon, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer. 2010. “The Effect of Corporate Taxes on Investment and Entrepreneurship.” American Economic Journal: Macroeconomics 2 (3): 31–64.

Fajnzylber, Pablo, William F. Maloney, and Gabriel V. Montes-Rojas. Forthcoming. “Does Formality Improve Micro-Firm Performance? Evidence from the Brazilian SIMPLES Program.” Journal of Development Economics.

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¹ The Investment Climate Impact Project is a joint effort of the World Bank Group’s Investment Climate Department, IFC’s Investment Climate Business Line, and the World Bank’s Development Research Group. For further information, please contact Massimiliano Santini.