Tax avoidance – Addressing tax evasion and tax avoidance in developing countries

1. Introduction
Most developed countries are characterized by a broad base for direct and
indirect taxes with tax liability covering the vast majority of citizens and firms.
Developing countries, in contrast, are confronted with social, political and
administrative difficulties in establishing a sound public finance system. As a
consequence, developing and emerging countries are particularly vulnerable to
tax evasion and avoidance activities of individual taxpayers and corporations.
This can be considered one of the primary reasons for large differences in the
ability to mobilize own resources between developed and developing countries.
While tax revenues in OECD-countries amount to almost 36 per cent of gross
national income in 20071, the share in selected developing regions amounts
around 23% in Africa (in 2007)2 and 17,5% Latin America (in 2004)3.

Nonetheless, tax revenue has increased over time in many low-income
countries. However, this development is mostly due to increased revenues from
natural resource taxes, e.g. income from production sharing, royalties and
corporate income tax on oil and mining companies and cannot be interpreted
as a sign of an improved tax system or administration.

Tax systems in many developing countries are characterized by tax structures
being not in line with international standards, by lack of tax policy
management, low compliance levels and inappropriate capacities in tax
administration. The difference in revenue mobilization also stems from
econo mic conditions (size of the informal sector). In fact, most developing
countries show a trend towards the prevalence of indirect taxation. Many of
them rely to a great extent on indirect taxes such as value-added taxes (VAT)
with indirect taxes amounting for up to two-thirds of total tax revenues.

In contrast, personal income taxes as a proportion of total tax revenue still play
a minor role in contrast to OECD countries. And although developing countries
still realize some of their domestic revenues through international trade taxes
and tariffs, they have declined over the last twenty years. Aside from these
structural differences in the tax systems between developing and developed
countries, it is important to recognize that tax losses that arise in the course of
tax evasion and avoidance activities do largely contribute to the poor
per formance of state revenue mobilization in developing countries.

Tax evasion and avoidance are both phenomena that are probably as old as
taxation itself. Wherever and whenever authorities decide to levy taxes,
individuals and firms try to avoid paying them. Though this problem has always
been present, it becomes more pressing in the course of globalization as this
process extends the range of opportunities to circumvent taxation while
simultaneously reducing the risk of being detected.

In the last couple of years, strengthening self financing capacities of development
countries has become a topic of increased concern and interest. Domes –
tic revenue mobilization as a central issue of the international development
agenda has been emphasized in both the Monterrey Consensus and the Paris
Declaration on Aid Effectiveness. This is due to a number of reasons.

Firstly, the establishment of own revenue raising abilities is crucial for any state
as it constitutes a prerequisite to ensure a sustainable development process
and implement pro-poor policies. Since self-financing capabilities in developing
countries are often not sufficient, generating tax revenue is highly relevant
for many developing countries.

Secondly, fair and efficient tax systems can contribute to good governance,
accountability of the state and democracy by establishing a bargaining process
between the state and its citizens: Governments that rely on broad based
taxation are forced to take the demands of their taxpayers into account. At the
same time, the way in which a government levies taxes essentially affects the
citizen’s identification with the state and its governmental agencies, potentially
increasing trust and compliance of its citizens and ultimately promoting
political participation.

Thus, besides generating public revenues, strengthening tax systems in
developing countries is equally important from a governance or state-building
perspective. Thirdly, revenue raising systems typically include the entire
population, thereby exhibiting a direct effect on the poor and their household
income. Designing a tax system in a pro-poor way can e.g. be achieved by
including a redistributive component. All in all, collecting a sufficient amount
of revenues is essential for a country to fund pro-poor programs, built effective
government institutions and strengthen democratic structures, stimulate
sustainable economic growth and reach national and international development
goals. To reach these goals it is, however, essential that the tax system is
imple mented the way it was designed. Thus, counterproductive activities like
tax evasion and avoidance practices, that undermine the intentions of the
system, need to be reduced.

The present study aims at developing a deeper understanding of the problem
of tax evasion and avoidance in developing countries. Against the background
of growing interest by international development cooperation, governments of
developing and developed countries and international institutions in this topic,
this study shall contribute to the systematization of knowledge.

It becomes apparent that although there is a theoretical basis explaining tax
evasion and tax avoidance behavior, we know little about the patterns and the
extent of tax evasion and avoidance in the regions of the world and the different
techniques used to evade and avoid paying taxes in individual developing
countries.

Section 2 focuses on the terminology of tax avoidance and evasion followed by
a presentation of governmental, cultural, social and legal factors that influence
the (voluntary) compliance with the tax system (Section 3).

Different modes of tax evasion and avoidance are outlined in Section 4.
Section 5 describes approaches and measures to combat and reduce the scope
of tax evasion and avoidance activities. The last section concludes.

2.1. Terms and definitions
The subject of tax evasion and avoidance embraces many dimensions and
problems. As there exists no clear-cut distinction between tax evasion and tax
avoidance, one firstly needs to define which practices can be considered as
violation or abuse of tax codes. To create a level playing field when discussing
these issues, the following terms and definitions are helpful.

Tax evasion in general refers to illegal practices to escape from taxation.To this
end, taxable income, profits liable to tax or other taxable activities are
concealed, the amount and/or the source of income are misrepresented, or tax
reducing factors such as deductions, exemptions or credits are deliberately
overstated (see Alm and Vazquez, 2001 and Chiumya, 2006). Tax evasion can
occur as an isolated incident within activities that are – in other aspects – legal.
Or tax evasion occurs in the informal economy where the whole activity takes
place in an informal manner – this means the business is not only evading tax
payments but is also not registered as formal enterprise at all.

Tax avoidance, in contrast, takes place within the legal context of the tax
system that is individuals or firms take advantage of the tax code and exploit
“loopholes”, i.e. engage in activities that are legal but run counter to the
pur pose of the tax law. Usually, tax avoidance encompasses special activities
with the sole purpose to reduce tax liabilities. An example for tax avoidance is
strategic tax planning where financial affairs are arranged such in order to
minimize tax liabilities by e.g. using tax deductions and taking advantage of tax
credits.

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2011-09-09_GTZ_Addressing-tax-evasion-and-avoidance

Table of Contents
1. Introduction 6
2. What is the issue? 9
2.1. Terms and definitions 9
2.2. Measuring tax avoidance and tax evasion 11
3. Reasons for tax evasion and tax avoidance 13
3.1. Low level of (voluntary) tax compliance 14
3.1.1. Low tax morale 14
3.1.2. High compliance costs 15
3.2. Weak enforcement of tax laws 16
3.2.1. Insufficiencies in tax collection 17
3.2.2. Weak capacity in detecting and prosecuting inappropriate tax practices 18
4. Modes of tax evasion and avoidance in developing countries 19
5. Strategies against tax evasion and tax avoidance 25
5.1. Measures improving tax compliance 25
5.2. Measures improving the ability to enforce tax laws 26
5.2.1. Addressing weak enforcement at the national level 28
5.2.2. International endeavours to strengthen national tax law enforcement 31
6. Summary and Conclusions 35
7. References

this version: 22 December 2010

Imprint
The International Tax Compact (ITC) is an international initiative
to fight against tax evasion and inappropriate tax practices in
developing countries. The German Federal Ministry for Economic
Cooperation and Development (BMZ) has launched the initiative
and commissioned GIZ with the implementation.

Published by
Deutsche Gesellschaft fur
Internationale Zusammenarbeit (GIZ) GmbH
Dr. Elke Siehl – Director of Division State and Democracy
Dag-Hammarskjold-Weg 1-5
65760 Eschborn
T +49 61 96 79-0
F +49 61 96 79-11 15
E info@giz.de
I www.giz.de/public-finance

Commissioned and supervised by
Deutsche Gesellschaft fur Internationale Zusammenarbeit
(GIZ) GmbH on behalf of
Federal Ministry for Economic Cooperation and Development (BMZ)
I www.bmz.de

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