Measuring tax effort: Does the estimation approach matter and should effort be linked to expenditure goals?

Abstract

In this paper we attempt to take a fresh look at the classical question of the determinants of tax effort. Our goal is to better understand the fundamental economic logic of the different approaches that have been used in the previous literature, consider alternative measurements which may provide a more direct intuition of what the concept of tax effort attempts to measure, and to compare quantitatively the rankings of tax effort produced by all these different approaches. As we see it, the fundamental issue is how to move forward toward a definition of tax effort that has a higher relevance to the developmental needs and budgetary ambitions of a country and as an indicator of potential tax reform needs. Fundamentally, all tax effort indicators are calculated by comparing actual collection performance against a measure of potential collections. This definitional choice lays out several dimensions for the conduct of tax policy in a country. These include the need for reform to raise revenues with reference to some potential, the desirable timing and urgency of those reforms, and the extent of the gains in national welfare that are achievable with these reforms. While the first two dimensions have been examined in different ways in the previous literature, in this paper, for the first time in this literature, we will examine how much the two different approaches to estimation of tax effort matter as compared to those conventionally used. In addition, and also for the first time in this literature, in this paper we argue for the need to explicitly link the adequacy of tax effort with the specific expenditure goals of government and their associated gains in national welfare.