Monday, December 5, 2011

Quality of tax administration:how relevant is country size?

A striking feature of the limited literature that exists on country size is that country size does not seem to matter much for various social and economic variables. For example, a recent study by Rose (2006) uses panel data for 200 countries and for over 40 years for a large number of socio-economic variables. However, the study fails to find any significant impact of country size on for example, income level, inflation, material wellbeing, health, education, quality of a country’s institutions and a number of different indices and rankings. The only exception is the volume of international trade (exports plus imports as a percentage of GDP) with small countries showing higher trade volumes than large countries. The present paper takes a novel approach towards uncovering the relevance of country size by using micro or firm-level data on firms’ experience with tax administration, an important but neglected aspect of the business environment. The results show that country size matters and in a robust way for the quality of tax administration. Implications of our findings for the broader literature are discussed.

Empirical work on the effect of country size on various social and economic variables is rather limited. However, theoretical studies suggest a number of channels through which country size may matter. For example Alesina and Spolaore (2003) list a number of country size related benefits that include lower per capita costs of public goods (monetary and financial institutions, judicial system, communication infrastructure, police and crime prevention, public health, etc.) and more efficient tax systems; cheaper per capita defense and military costs; greater productivity due to specialization (though access to international markets may reduce this effect); greater ability to provide regional insurance; and greater ability to redistribute income within the country. Against these potential benefits, there are some disadvantages of being large. For example, it is argued that larger countries have more diverse preferences, cultures and languages and this greater heterogeneity of preferences may make it more difficult to reach consensus on growth enhancing reforms. Another potential problem with large countries is congestion or administrative costs that may escalate with country size.

Our focus on tax administration is motivated by two factors. First, as mentioned above, scale effects suggest that the cost of providing public goods may depend significantly on country size. However, it is also possible that congestion costs may lead to more complicated, inefficient and unwieldy tax systems among the relatively larger countries. Given these contrasting scale and congestion effects, what can we say about the quality of tax administration in small vs. large countries? The present paper attempts to answer this question. Second, anecdotal evidence suggests that tax administration is an important element of the business climate. However, very little is known about the quality of tax administration and the sorts of factors that determine it. For example, in the survey of over 11,000 firms in 30 countries in Eastern Europe and Central Asia conducted by the World Bank in 2008 that we use for the present study, more than 20 percent of the firms reported tax administration as a major or a very severe obstacle for their business and another 24 percent as a moderate obstacle. For a comparison, the corresponding figures for obtaining licenses and permits as reported in the survey are 17 and 18 percent, respectively. The use of micro data complements existing studies that are exclusively focused on macro or country level data. Specifically, we use a survey of non-agricultural firms in 30 countries in Eastern Europe and Central Asia conducted by the World Bank in 2008.

The survey reports firms’ experience with the quality of tax administration as measured by how severe is tax administration (on a 0 to 4 scale) as an obstacle to the current operations of the firm. Use of such experienced based measures is becoming increasingly popular in the literature. For example,Beck et al. (2005) use the severity of access to finance as an obstacle to firms’ operations as perceived by the firms and show that the severity level is inversely correlated with firm growth; Djankov et al. (2003) show that a higher degree of judicial formalism is associated with lower perceptions of enterprises of courts’ fairness, honesty and consistency; Beck, Demirguc-Kunt and Levine (2006) and Barth et al. (2009) show that a more market-based supervisory approach and more efficient systems of credit information sharing are associated with lower financing constraints as perceived by the firms. Also see for example, Beck et al. (2010) and Safavian and Sharma (2007)
World Bank.Author:Amin, Mohammad.Document Date:; 2011/12/01.Document Type: Policy Research Working Paper.Report Number: WPS5895.Volume No: 1 of 1