Front Matter

Front Matter

Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie
Published Date:
June 1987
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© 1987 International Monetary Fund

Reprinted March 1995

Cover design by the IMF Graphics Section

Library of Congress Cataloging-in-Publication Data

Supply-side tax policy.

Bibliography: p.

1. Taxation-Developing countries. 2. Supply-side economics-Developing countries. I. Gandhi, Ved P. (Ved Parkash)

HJ2351.7.S86 1987 336.2’009172’4. 87-29890

ISBN 9780939934911

Price: $20.00



The decade of the 1980s is likely to be remembered as the time when tax reform became fashionable around the world. Not only many industrial countries but also many developing and centrally planned countries have felt the need to reform, sometimes drastically, their tax systems. While in earlier periods reforms often had the objective of raising revenue and of making the tax system more progressive, during the 1980s most tax reforms have been revenue neutral in intention, if not always in actual results, in spite of the large fiscal deficits that have characterized many of these countries. The main objective of the recent reforms has been the removal of obstacles to growth. In the industrial countries, the concern about the relationship between the tax system and the rate of economic growth has been heightened by the high and increasing unemployment rates that have accompanied the slowdown of their rate of economic growth in recent years. In the developing countries, there has been the realization that heavy debt burdens could only be reduced by accelerating the rate of growth of these economies. Furthermore, in view of the low levels of income in these countries, growth had always been a major objective for their policymakers.

In this period, both economists and policymakers have rediscovered the importance of supply-side aspects of economic policy. While up to recently economic policy had been driven by the Keynesian assumption that regulating aggregate demand would go a long way toward achieving whatever economic objectives the policymakers wanted to achieve, during the 1980s the focus of policymakers’ attention shifted from the demand to the supply side of the economy. They came to believe that it would be possible to squeeze a larger growth rate out of the existing resources if certain changes were made in economic policies. For the tax system, these changes were often thought to require reductions in tax rates accompanied by broadening of bases. They also required reductions in the differential treatments of economic sectors and economic activities.

In spite of the fact that many observers think of the Fund as an institution concerned mainly with stabilization, it has, in fact, always paid attention to the objective of economic development. As a consequence, it was natural that it would be influenced, like everybody else, by the current thinking about the role of incentives in general and tax incentives in particular. The Fund has paid increasing attention to the structural components of adjustment policies. It has accepted the conclusion that without major structural adjustments developing countries might achieve stability, but only at the cost of a slower rate of growth. Stability with growth requires that many changes in the structure of their economies must take place in these countries. There must be changes in the external sector through the liberalization of imports and the removal of impediments to exports, in addition to the more traditional adjustments in the exchange rate. There must be changes in the financial markets, through the removal of obstacles to the flow of financial resources within the economy, through the raising of real interest rates to realistic levels, and through the reduction of the proportion of total credit that is administratively allocated. There must be realignments in relative prices in order to eliminate disincentives to producers, when the prices that they receive are too low to keep them producing the cash crops for which the countries have comparative advantages. There must also be changes in the relative prices of consumer goods to reduce the consumption of products that must be imported or that could be exported in larger quantities.

The restructuring of economies will inevitably involve also the reform of the tax system. This is the aspect addressed in this book. Under the direction of Ved Gandhi, Chief of the Tax Policy Division, the Fiscal Affairs Department has made a systematic attempt at surveying what is known about the disincentive effects of taxes. This research has relied on hard evidence in order not to be swayed by claims that may be fashionable but that are often not fully substantiated. This reliance on hard evidence has obvious scientific merits, but it has also some shortcomings. The merits are that the conclusions reached are based on firm evidence. The shortcomings are that those conclusions are based on work which has already been done; that work may itself have been biased by earlier preconceptions about the effect of taxes. In any case, I hope that enough interesting conclusions are provided by this book to make it a valuable addition to the literature on taxation in developing countries. I also hope that policymakers will find some of its conclusions useful for the conduct of their economic policy. I should perhaps conclude by adding that the views presented reflect the thinking of the authors and do not necessarily reflect official Fund positions.



Fiscal Affairs Department


A striking feature of the 1980s has been the sharp decline in the rates of growth witnessed by countries in the developing world. According to the World Bank’s World Development Report, 1986, the average annual rate of growth of these countries declined from 6.6 percent during 1965-73 and 5.4 percent in 1973-80 to 2 percent in 1982 and 1983 (Statistical Appendix Table A.3, page 115). Countries all over Africa as well as Latin America and the Caribbean have experienced a significant erosion of the standard of living of their populations in recent years, as their economic growth rates have fallen far short of their population growth rates, and there is little hope for early reversal of these trends. Given the uncertain prospects for growth, many economists have expressed the belief that exclusive reliance on traditional demand management policies, which can certainly achieve successful stabilization around a trend growth path, may not be enough to improve economic welfare and that these policies may have to be combined with policies aimed at raising the trend growth path itself. This belief has renewed the interest of economists and policymakers alike in the determinants of growth and supply-side economics with its fundamental claim to enhancing the country’s potential for growth.

Although supply-side economics addresses all aspects of aggregate supply, it focuses particularly on the appropriate role of government in encouraging growth through its expenditure and taxation policies. This book examines the relevance to developing countries of the tax policy recommendations of supply-side economists and attempts to delineate policy guidelines to ensure that fiscal management enhances rather than inhibits growth and efficiency in the wider economy.

The book is the product of a research project initiated in 1984 in the Fiscal Affairs Department of the International Monetary Fund to assess the relevance to the special circumstances of developing countries of tax policy aspects of the popular supply-side revolution in the United States. The main emphasis of the popular version of this revolution has been to stress the negative effects of high income tax rates on incentives to produce, save, and invest and, through these, on the growth of the economy.

Assessing the relevance of supply-side tax policy for developing countries is no easy task. First, there are many forms of taxes and the effects of each tax on incentives have many aspects. Effects of tax rates, the primary focus of the popular supply-siders, on the behavior of the economic agents are interwoven with the type and scope of the tax base, tax reliefs, and tax incentives, and many other special provisions of the tax system. Second, tax policy frequently interacts with other economic policies of the government in very many complicated ways so that the economic effects of a tax cut become a function of the institutional and economic policy environment within which it operates. Furthermore, statistical and other information relevant to estimating the disincentive effects of various tax policies or the incentive effects of the reform of such policies are not readily available.

The book does not purport to be comprehensive; it covers only selected aspects of supply-side tax policy. In particular, it attempts to deal with the following eleven questions:

  • What are the most important price elasticities that determine the effects of income tax reductions on aggregate supply?
  • How price-sensitive are labor supply, savings, and investment in developing countries?
  • To what extent do income tax policies, given certain other economic policies, reduce financial savings in developing countries?
  • To what extent do income and corpopate tax policies, given generous tax incentives and other tax provisions, reduce corporate investment in developing countries?
  • Do high and progressive income tax rates significantly increase income tax evasion in developing countries?
  • Are there certain examples from the developing world where a reduction of top marginal income tax rates has increased government revenue significantly in the short run as predicted by the “Laffer curve?”
  • What is the econometric evidence on the negative relationship between reliance of developing countries on income taxes and their growth rates?
  • What will the tax systems of developing countries look like in theory if incentives and efficient allocation of resources were the major concern of policymakers?
  • How efficient are the generous tax incentives that are frequently given to investors in developing countries in order to induce economic growth?
  • Under what circumstances are export duties justified on grounds of efficiency and growth?
  • What is the precise role of tax policy in removing the various structural bottlenecks to economic development and helping the growth of developing countries?

Chapters 2 through 12 deal with each of these questions, while Chapter 1 brings together the findings and conclusions of the analyses and suggests ideas for supply-side tax reform relevant for developing countries.

The research project was carried out by a staff team headed by Ved P. Gandhi of the Tax Policy Division of the Fiscal Affairs Department. In addition, the team consisted of Liam P. Ebrill, Jitendra R. Modi, Somchai Richupan, Fernando Sanchez-Ugarte, and Parthasarathi Shome. The papers included in this book were prepared by the staff members as and when they found time in the course of their regular operational work for the Fund. The papers by George A. Mackenzie and Luis A. Mañas-Antón were not prepared as a part of the project; the former was completed before the research project was initiated, while the latter was prepared when the author served as a summer intern in the Tax Policy Division.

The research project was a cooperative effort, and the author of each paper has benefited from the comments of the other members of the staff team. In addition, many friends and colleagues in the Fiscal Affairs Department, as well as in other departments of the Fund, took pains to read the draft papers and provide guidance, and their advice is gratefully acknowledged. The team is particularly indebted to Vito Tanzi, Director of the Fiscal Affairs Department, who took interest in the research project from its inception, provided an exciting environment, and guided the work of the team; the book owes a great deal to him. The team also wishes to thank Alan Tait, Leif Mután. Robert Schneider, Richard Hemming, Sheetal Chand, David Nellor, and Charles Sisson, who gave constructive criticisms on one or more draft papers. Extensive comments on the entire manuscript and valuable suggestions were received from Professor Roy Bahl of Syracuse University and Professor Charles McLure, Jr., of Stanford University and the authors wish to express their gratitude to them. However, none of the foregoing can be held responsible for any errors or omissions that may remain. The authors also wish to express appreciation for the painstaking and skillful editing of the manuscript by Esha Ray. Finally, thanks are due to Lyndsey Livingstone and Ahwerah Vichailak for their patience and superb job of typing and retyping successive drafts of each paper until the final manuscript stage.

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