9002lirpA IN PRACTICE investment climate BUSINESS TAXATION 3.on 48312 Tackling Corruption through Tax Administration Reform Aminur Rahman A weak tax administration encourages corruption that benefits both Aminur Rahman (arahman@ ifc.org) is an investment government officials and businesses at the expense of overall tax revenue. policy officer in the World Bank Collusive corruption is at the heart of most, if not all, problems related Group and a member of the Investment Climate Depart- to tax administration. This note examines the drivers of corruption ment (CIC) business taxation and suggests good-practice measures for reforming tax administration. product team. He advises cli- It is one in a series addressing issues that governments of developing ent governments in developing countries on implementing tax countries face in reforming their tax systems. reforms that will reduce barri- ers to compliance, investment, A well-functioning tax administration is Tax corruption raises "black money," hidden and economic growth. fundamental in promoting formal business income used for briberies related to other activities, investment, and economic growth. In government regulations, procurement, and This note, one in a series on many countries, however, tax administration is informal economic activities. business taxation reform, was rated by businesses as a key constraint to doing business. A malfunctioning tax administration What drives the demand for developed as part of a joint raises the cost businesses incur in complying tax corruption? program between the United with the government's tax requirements. This Kingdom's Department for leads to firms and tax officials colluding outside A business is willing to bribe if it reduces the tax International Development the system at the micro level and a high degree of payment and saves the time involved in tax (DFID) and CIC. The program mistrust between business and government at audits. For instance, in Yemen, businesses report focuses on operational issues the macro level. that paying a bribe of 25-40 percent of the tax assessment can lower the assessment by 50 in tax reform, particularly those Corruption is often viewed as a predatory act: percent. In many developing countries, large related to micro-enterprises government officials prey on businesses that firms take this opportunity (and exploit the and small businesses. become the victims. However, tax corruption is loopholes in tax laws) to informally negotiate a win-win situation for both tax officials and and file tax returns under the presumptive The IN PRACTICE note series firms. A bribe is not necessarily an administrative regime designed for small businesses, without discusses practical consid- extortion, but rather a business transaction disclosing the accounts. yielding a lower tax payment for the company erations and approaches for and unofficial, "tax-free" income for the tax Weak enforcement often means there is no implementing reforms that official at the expense of national income. significant risk of detection and punishment, aim to improve the business Collusive corruption among firms is exhibited in which further encourages corrupt behavior. A environment. IN PRACTICE is non-compliance of tax payments, misreporting high tax burden and compliance cost can published by the Investment of business activities, informal negotiations on exacerbate the situation. Moreover, the inevitable Climate Department of the tax obligations, unofficial payments to the question remains: "Why would I pay tax?" In the collectors, and revenue loss for the government. absence of any tangible benefits of public World Bank Group. spending, taxpayers in many countries do not feel a and procedures; non-transparent hiring and civic obligation to pay tax, believing their income is reward mechanisms; a low level of skills; a lack of taxed to pay the salaries of corrupt public officials. professional ethics and integrity; low pay and a lack of incentives; conflicts of interest; the "get- rich-quick" syndrome; and insufficient checks and What drives the supply of balances within the administration. tax corruption? Despite the often robust demand, the key drivers Good-practice reform of tax corruption are on the supply side. In many measures countries, offering a bribe is the only way to avoid harassment from tax officials. Refusal to pay bribes Tax reform measures should tackle both the may result in endless inspections (and require- demand (businesses) and supply (tax ments) that can last for months and waste administration) side drivers of corruption. The significant senior management time. challenges of weak administration and pervasive corruption are closely related and mutually Similarly, while appeal procedures exist in many reinforcing. Thus, good-practice reform measures countries, they are not credible. Firms usually do aimed at tax corruption also reflect the key features not try to appeal; they view the decisions in most of modern tax administration. cases as favoring the tax authority and penalizing businesses with heavy fines and imprisonment. A typical technical assistance program for tax During the long period of settlement, the firm administration reform addresses several reform may also face pressure from tax officials to measures in strategic sequence. In the short term informally settle with a bribe. Consequently, (within 18 months), the program aims to simplify companies often decide not to enter into a dispute. tax instruments and processes; facilitate underlying legal reforms; consolidate subnational taxes and The underlying causes that drive corruption among fees; and provide training and capacity building tax officials include: complex and unclear tax laws for tax officials and the private sector to successfully implement the streamlined, consolidated tax instruments and processes. In the medium-term (within 36 months), the program will redesign tax Six Reasons to Reform Tax Administration administration architecture that involves institutional autonomy; reorganize the system and Tax administration is a critical determinant in the investment services based on types of taxpayers; and implement climate. Improving it can help attract more investment to increase human resource management policy, automation, growth and reduce poverty. incentive mechanisms, and checks and balances. Tax reform reduces the compliance cost and broadens the tax net, enabling the government to raise revenue with a lower tax rate and to Short- to medium-term equitably distribute the tax burden. reform implementation For any given tax policy, a well-functioning administration raises more revenue than a malfunctioning one. Simplify, standardize, and harmonize tax procedures. A simpler process reduces tax officials' Tax policy reform without administrative reform is not fruitful in an discretionary power and abuse of tax laws, lessening environment of mistrust; the good intentions of either tax officials or the burden for firms to comply. For example, businesses are cynically viewed by the other party. Colombia recently carried out a systematic study Tax corruption propels corruption in other areas; reform is essential of important business processes and prepared a to cut the "supply lines" of corruption. map of corruption risks to guide procedural changes. Latvia and Jamaica reformed their tax and A modern tax administration is necessary to keep up with the increasing sophistication of firms' operations in the era of customs codes to reduce the discretion of revenue officials and simplify procedures. globalization. IN PRACTICE BUSINESS TAxATIoN 2 Enforce compliance and target corruption with corruption, as has been demonstrated in the a strengthened legal framework and adminis- Philippines and Nepal. Automation is a key feature tration. A lower tax burden will not increase of modern tax administration. It efficiently collects compliance without an effective enforcement information from taxpayers and other parties (such mechanism. The laws should enforce record as banks and government agencies) and keeping, return filing, voluntary registration, and electronically supports clerical functions. It enables arrearscollection.Underself-assessment,compliant businesses to file returns and to easily and quickly taxpayers should be free to conduct business declare and pay taxes. Automation is also essential without abusive auditing, and those considered for risk-based management approaches. non-compliant should be penalized. The legal framework should reflect "zero tolerance" for Introduce an effective human resource corruption. If proven guilty of corruption, the management policy. The administration should offenders--whether they are tax officials or firms-- have a transparent, fair, and streamlined policy for should be punished. recruitment, performance appraisal, career development, and compensation including Conduct taxpayer outreach and education. incentives. Staff professional development needs to Educating taxpayers reduces firms' misconceptions include an anti-corruption focus, ethics, and code and confusion about tax policies and procedures, of conduct. Employee achievements in detecting and raises their awareness on the benefits of proper tax fraud, attaining client satisfaction, and record-keeping, such as quick assessments and less improving revenue collection should be recognized. likelihood of being audited (and less intrusively, if Latvia, the Russian Federation, and Colombia have audited). It also works to instill trust between the focused on strengthening their tax administration administration and business. In Uganda, Rwanda, management. Many countries have used revenue and South Africa, outreach activities have included administration restructuring to establish human TV and radio coverage, advertising, and tax- resource management principles and terminate themed school programs to help children corrupt officials. In Guatemala, Peru, and Jamaica, understand the civic responsibility of paying taxes. a rigorous process of psycho-metric tests, job- specific skill tests, interviews, and personal record Institutionalize an effective control and audit reviews was used to weed out corrupt and under- system. Experience suggests that most firms will performing employees. To improve tax officials' comply in paying taxes if they understand their pay (thus lowering the incentive for corruption), obligations, and if they see the tax administration is some countries have disassociated revenue fair in handling non-compliance. The risk-based administration staff salaries from general civil auditing system enables effective auditing and service pay. In Guatemala, the salaries of top efficient management of the administration's managers were increased significantly. Jamaica resources. A number of countries, including Chile, created a separate pay scale for tax administration Colombia, and Hungary, have implemented staff. Russia and Albania allowed managers to give systems that compile information from various performance-based bonuses. sources to create risk profiles. Hungary has imported a system that guides auditors through the steps of Institutionalize a streamlined and transparent an audit. Other measures include: streamlining the appeal procedure. An unbiased, quick, and reporting arrangement for audits; rotating auditors transparent appeal process helps firms develop to prevent corrupt affiliations between auditors and trust in the overall system. In shortening the audited firms; and implementing a system to process, the tax authority can limit abuse by firms monitor individual auditors. that appeal in order to defer paying taxes over an extended dispute period. The Revenue Appeals Tribunal, a process widely used in the United Medium- to long-term reform Kingdom, Canada, and Uganda, can be expedient implementation in moving trials to conclusion. Institutionalize e-services and automation. Reorganize tax administration by type of Reducing face-to-face interactions between taxpayer. To increase efficiency and effectiveness, businesses and tax officials limits opportunities for the tax authority headquarters and local office IN PRACTICE BUSINESS TAxATIoN 3 network should be rationalized and streamlined processesdoesnotautomaticallyensurecompliance. based on the different sizes of taxpayers. Most Businesses can still evade tax without a strong revenue administrations are moving toward this enforcement mechanism. Enforcement should be sort of institutional restructuring. Segmented matched with appropriate checks and balances in service delivery enables the tax authority to better administration or tax officials will abuse their understand each category of firms, allowing for power. Similarly, in an atmosphere of mistrust (and informed monitoring of taxpayers and tax officials. lack of confidence in the judicial system), firms For instance, under a size-specific structure, it is seldom use an appeal mechanism and complaint more difficult for larger firms to hide profit or hotlines because they believe the decisions will income and file as small firms. A functional penalize them and favor tax officials. organization structure has been implemented in Latvia, Jamaica, and Russia. A large taxpayer's Pay raises and bonuses for tax officials, or office has been successfully established in South institutional autonomy for that matter (which is Africa, most transition countries, and in many politically challenging to achieve), are not a panacea countries in Latin America. to stop tax officials' rent-seeking behavior. As evidenced in Uganda, Ghana, and Tanzania, the Ensure the tax authority's autonomy. Although initial gain in terms of improved revenue collection the tax authority is often attached to the Ministry due to pay raises or institutional autonomy is not of Finance, measures should be taken to strengthen always sustainable without checks and balances and the administrative autonomy of tax services. The punitive measures against corruption. In an effectiveness of the measures discussed above-- environment where corruption is a way of life and incentives and penalties, streamlined operations, the tax authority's higher tiers share the proceeds of management and control--crucially depends on thelowertiers'bribery,thesesortsofadministration- both organizational and budgetary autonomy. wide measures against corruption are difficult Autonomy increases the transparency of the tax without support at the highest levels of the administration and its budget and the effectiveness government (which is also not prone to election and efficiency of its expenses. It is important in results and changes in political leadership). The World Bank Group's Investment promoting merit-based recruitment, performance- Climate Department (CIC) is the op- based career development, and professional skill The key to sustainable progress against corruption erational center for IFC's Business En- development. Autonomy minimizes the chances of lies in sequencing the measures of an overall abling Environment Advisory Services the administration's involvement in political strategy for reform. While each measure addresses corruption and client favoritism. a specific driver of corruption and a full reform and FIAS, the multi-donor investment package must be implemented over the longer climate advisory service. CIC assists the term (or widespread corruption will prevail governments of developing countries Conclusion through the weaker links in the system), a and transition economies in reform- manageable and logical sequencing first addresses ing their business environments, with An important lesson in tax administration reform, the shorter-term implementation components (tax emphasis on regulatory simplification as experience around the world indicates, is that instruments and processes, taxpayer awareness, undertaking reforms on a piecemeal basis does not and the underlying legal and administrative and investment generation. The find- yield the desired results because each reform framework). It does not make sense, for instance, ings, interpretations, and conclusions measure is critically interlinked with others. to address human resource policy before an audit included in this note are those of the Therefore, designing and enacting a comprehensive and control system is in place. Thus, author and do not necessarily reflect reform package requires continued and strong implementation of the shorter-term measures the views of the Executive Directors of political will over time. provides a basis for longer-term structural and the World Bank or the governments institutional reform, such as reorganization of the Understanding how reform measures work together tax administration architecture. they represent. is key in addressing challenges on the ground in Further reading on this topic is available from the their implementation. For instance, simplifying author upon request. WWW.fiAS.neT