Includes bibliographic footnotes(p.14-15)

Leuthold, Jane H.

N'Guessan, Tchetche

English

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Tax buoyancy vs elasticity in developing economy

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UNIVERSITY OFILLINOIS LIBRARYAT URBANACHAMPAIGNBOOKSTACKSCENTRAL CIRCULATION AND BOOKSTACKSThe person borrowing this material is re-sponsible for its renewal or return beforethe Latest Dote stamped below. You maybe charged a minimum fee of $75.00 foreach non-returned or lost item.Theft, mutilation, or defacement of library materials can becauses for student disciplinary action. All materials owned bythe University of Illinois Library are the property of the Slateof Illinois and are protected by Article 16B of Illinois CriminalLaw and Procedure.TO RENEW, CALL (217) 333-8400.University of Illinois Library at Urbana-ChampaignWhen renewing by phone, write new due datebelow previous due date. L162^ BEBRFACULTY WORKINGPAPER NO. 1272Tax Buoyancy vs Elasticity in a Developing EconomvJane H. LeutholdTchetche N'GuessanCollege of Commerce and Business AdministrationBureau of Economic and Business ResearchUniversity of Illinois, Urbana-ChampaignBEBRFACULTY WORKING PAPER NO. 1272College of Commerce and Business AdministrationUniversity of Illinois at Urbana-ChampaignAugust 1986Tax Buoyancy vs Elasticity in a Developing EconomyJane H. Leuthold, ProfessorDepartment of EconomicsTchetche N'GuessanNational University of the Ivory Coast in AbidjanDraft: Not for quotation.We are grateful to the African Studies Center at the University ofIllinois, to the Midwest Universities Consortium for InternationalActivities, and to the Centre Ivorien de Recherches Economiques etSociales in Abidjan for support of this research.Digitized by the Internet Archivein 2011 with funding fromUniversity of Illinois Urbana-Champaignhttp://www.archive.org/details/taxbuoyancyvsela1272leutABSTRACTThe concepts of tax buoyancy and tax efficiency are used to mea-sure the responsiveness of tax revenue to economic growth. Taxbuoyancy is a crude measure which does not distinguish between dis-cretionary and automatic growth of revenue. Elasticity is a preferredmeasure of tax responsiveness since it controls for automatic revenuechanges. In this study, the buoyancies and elasticities of the majortaxes in a representative developing economy, the Ivory Coast, areestimated using alternative estimation techniques and comparisons be-tween buoyancies and elasticities are drawn. In general, tax receiptsin the Ivory Coast tend to be slightly inelastic while particulartaxes such as the value added tax are highly elastic. The results ofthe study have important policy and research implications.TAX BUOYANCY VS ELASTICITY IN A DEVELOPING ECONOMYTax buoyancy is a measure of the responsiveness of tax receipts toeconomic growth. A tax which is buoyant is one whose revenues in-crease by more than one percent for a one percent increase in nationalincome or output. In measuring buoyancy, no attempt is made to con-trol for discretionary changes in the tax system or administration.Consequently, buoyancy reflects both discretionary changes and auto-matic revenue growth.For policy purposes, it is usually useful to distinguish betweenrevenue growth due to discretionary changes and revenue growth due tochanging economic conditions. Tax elasticity is a measure designedfor this purpose since it measures the responsiveness of tax revenueto a change in national income or output after controlling forexogenous influences such as discretionary changes in tax policy. Ifa tax is elastic, a one percent increase in GNP or GDP results in agreater than one percent increase in revenue from the tax holdingconstant for discretionary tax changes.For various reasons, studies of tax responsiveness often focus ontax buoyancies rather than tax elasticities. One problem is inobtaining information on discretionary revenue changes. Sometimesthis information is available through the Minister of Finance, howeverthis source may not know or be willing to report the discretionaryrevenue change. At best, the information is an estimate which may ormay not be based on a sound economic model.Secondly, utilizing information on discretionary revenue changesto control for such changes may result in the loss of degrees of-2-freedom in a regression analysis. This is a particular problem in thestudy of developing economies since the data series are usually shortto begin with. Each new control variable reduces the number ofdegrees of freedom by one, reducing the efficiency of the regressionestimates.The purpose of the present study is to utilize tax revenue datafrom a representative developing economy, the Ivory Coast, to estimatetax buoyancies and elasticities using alternative techniques and toevaluate these techniques on the basis of the estimation. A briefdescription of the tax system in the Ivory Coast follows in section I.In section II is a discussion of the methodology used in this studyand section III is a presentation of the results. Section IV is asummary and evaluation.I. The Tax System in the Ivory CoastThe tax structure in the Ivory Coast is characteristic of that ofmost developing economies. The composition of the tax structure in1979 is shown in Table 1. The heavy emphasis on trade and consumptiontaxes coupled with a lesser reliance on income and property tixes iscommon in developing countries.Import duties provide the most important source of revenue in theIvory Coast. Duties on imports are levied at rates up to fortypercent. The second most important revenue source is the value addedtax which is similar in operation to the European value added taxesbut is limited to the manufacturing stage. Foodstuffs and exports areexempt from the tax and rates are graduated over commodity types witha 10 percent rate for quasi-necessities and 20 and 26 percent rates-3-Table 1 The Composition of the Tax Structurein the Ivory Coast, 1979INCOME TAXATIONProfits taxIndividual income taxOther income taxesCONSUMPTION TAXATIONValue added taxesExcise taxesTobaccoAlcoholic beveragesGasolineTimberPercent of Revenue15.77.25.13.324.15.31.5.43.432.22.8PROPERTY TAXESReal estate taxMotor vehicle tax.9.21. 1TRADE TAXESImport dutiesExport dutiesOTHER41.07.948.9TOTAL 100.1Source: Fonds Monetaire International, Analyse et ProgrammationFincincieres : Application a la Cote d' Ivoire,Washington,D.C.,p. 223.-4-for luxuries. The tax is imposed on the manufacturing sector withcredits for taxes paid on inputs, including investment goods. TheIvory Coast also has a turnover tax on services but service firms mayopt for the value added tax.The individual income tax in the Ivory Coast is schedular in form.Wages and salaries are subject to four different income taxes. TheIvory Coast follows the French pattern of splitting income amonghusband, wife and children with the husband and wife each allocatedone part and each child one-half part up to a maximum of five parts.Rates are graduated up to 60 percent; however, the maximum effective2rate is around 33 percent.Corporate income is subject to three taxes, a tax on corporateprofits, a national contribution, and a national investment fund whosecombined rates are 50 percent. The tax on corporate profits offers afive year exemption for new businesses with prior approval. A 50percent investment allowance is also granted for investment in theconstruction of new buildings or in manufacturing or similar projects.Other taxes include excise taxes on tobacco, alcoholic beverages,and gasoline, a timber tax, and two property taxes, one on real estateand the other on motor vehicles. Together, these taxes account forless than 10 percent of total revenue.II. Techniques for Estimating Tax ElasticitiesAs noted earlier, tax buoyancy measures the responsiveness of taxrevenue to changes in income or output with no attempt to control fordiscretionary changes in policy. The traditional way to estimate theelasticity of a particular tax, k, is with the following model:-5-(1) log Tk= aQ+ a1log GDP + eRwhere T is tax revenue, GDP is gross domestic product, and e is astochastic disturbance term. Ordinary least squares is used to esti-mate the coefficients a and a.. Since the equation is in double-logform, a provides an estimate of the tax buoyancy because it measuresthe percentage response in the left-hand variable for a one percentchange in the right-hand variable.Estimating tax elasticity involves modifying the above model toaccount for discretionary changes in tax policy. One technique fordoing this was developed by Prest in studying the personal income tax3in the United Kingdom. The technique has been used in severalstudies including one by Mansfield in 1972. It involves cleansingthe data of discretionary revenue changes using data on discretionaryrevenue provided by the Minister of Finance. This is accomplished byapplying the following formula to the data to compute the adjusted taxreceipts, AT:(2) AT.= T .[AT ,/(T -D xin-j n-j n-j+1 n-j+1 n_j +1 ^Jfor j = l,2,...,n-l where T is actual tax receipts and D is estimateddiscretionary tax receipts. The subscript denotes the year of thedata. Basically, the technique computes what the tax receipts wouldbe in the absence of a discretionary change. An important underlyingassumption of this technique, which may or may not be satisfied in aparticular case, is that the discretionary changes are no more or lessprogressive than the tax structure they modify.-6-Once the data have been cleansed by the above technique, model (1)is reestimated on the adjusted data:(3) log ATk= bQ+ b1log GDP + ekand b provides an estimate of the elasticity of the kth tax.A second technique for estimating tax elasticity is the dummyvariable technique developed by Singer. This technique involvesintroducing a dummy variable into model (1) for each exogenous policychange. The revised model takes the form:(A) log Tk= cQ+ Cj log GDP + Z c2iV±+ ekiwhere the dummy variable, D, takes on the value before the discre-tionary change and 1 after the change. The summation accounts for thepossibility of multiple changes during the period. In this model, thecoefficient c estimates the elasticity.The Prest and the Singer techniques were used in this study toestimate the elasticities of Ivorian taxes. The study used Inter-national Monetary Fund data for the period 1970 through 1979. Theresults of utilizing these estimation techniques are reported in thenext section.III. Tax Buoyancy and Elasticity EstimatesTo provide a basis of comparison, buoyancy estimates for each ofthe major Ivorian taxes were obtained through the ordinary leastsquares estimation of model (1). The results of this estimationappear in Table 2. The buoyancies given by the a were all signifi-cantly different from zero at the .99 confidence level. For all but-7-Table 2 Buoyancies of the Major IvorianTaxes, 1970-79Tax aoaiR" D.W.All taxes -1.486** .983** .997 1.676Income and profits taxes -2.698** .880** .933 1.263Income tax -3.606** .841** .826 1.556Profits tax -3.352** .870** .962 1.022Consumption taxes -4.425** 1.229** .993 2.191Value added tax -6.709** 1.492** .990 1.546Excise taxes -1.019 .519** .813 1.055Gasoline tax -3.015** .729** .924 1.475Trade taxes -1.679** .916** .993 2.128Import taxes -3.214** 1.098** .996 2.110Export taxes .582 .373** .822 2.762**Signif icant at the .99 confidence level.-8-the income tax, excise taxes, and export taxes, the model fit the datavery well according to the R-squared statistic which measures thegoodness of fit and the Durbin-Watson statistics indicated no problemof autocorrelation among the residuals except for the profits tax andthe excise taxes.As seen in Table 2, the most buoyant Ivorian tax is the valueadded tax. Value added taxes in developing economies tend to be amongthe more elastic taxes especially if they exempt foodstuffs as in thecase of the Ivory Coast and if they are administered well. The otherbuoyant taxes are total consumption taxes and import taxes. Theremaining taxes have buoyancies less than one meaning that a onepercent increase in GDP results in a less than one percent increase intax revenue. The least buoyant tax is the export tax followed byexcise taxes. Overall, the tax system in the Ivory Coast is roughlyunit buoyant with a one percent increase in GDP being matched with a98.3 percent increase in tax revenues.The results of applying the Prest technique to first cleanse thedata of discretionary changes and then to estimate the model usingordinary least squares are shown in Table 3. The coefficient bestimates the elasticity and is always significant at the .99 confi-dence level. In all but one case, the elasticity estimated using thePrest technique is smaller than the buoyancy. This is expected sincethe elasticity measures the responsiveness of tax receipts to economicgrowth net of discretionary changes. In the case of the value addedtax, the elasticity and buoyancy are identical because the discretion-ary changes in that tax were negligible.-9-Table 3 Elasticities of Major Ivorian TaxesUsing Prest Technique, 1970-79Tax boblR 2 D.W.All taxes -1.321** .961** .997 1.700Income and profits taxes -2.429** .844** .928 1.218Income tax -3.370** .809** .819 1.591Profits tax -2.932** .812** .954 .948Consumption taxes -A. 347** 1.218** .993 2.273Value added tax -6.708** 1.492** .990 1.537Excise taxes -.801 .491** .789 1.036Gasoline tax -2.605** .675** .903 1.365Trade taxes -1.477** .890** .994 2.204Import taxes -3.028** 1.075** .996 2.014Export taxes .806** .344** .806 2.811**Signif icant at the .99 confidence level.-10-Finally, the results of applying the Singer dummy variable tech-nique appear in Table A. In applying this technique, a dummy variablewas created if a discretionary change resulted in a greater than threepercent change in tax revenue. The dummy variable equalled one in theyear of change and each year following. In only four cases, alltaxes, excise taxes, the gas tax, and export tax, were there discre-tionary changes of significant magnitude to warrant a dummy variable.In all cases, the coefficients of the dummy variables were not sig-nificant at the .99 confidence level. However, except for the exporttax, the coefficient c estimating the elasticity was significantlydifferent from zero at the .99 confidence level.A comparison of the elasticity estimates using the Prest techniquewith those using the Singer technique suggests that the techniquesgive roughly the same estimates for total taxes and for the gas tax.However, excise taxes are more elastic under the Singer techniquewhile export taxes are more elastic under the Prest technique. Inchoosing between the two techniques, the Prest technique has severaladvantages. First, the Prest technique preserves the degrees offreedom which are lost each time a dummy variable is used in theSinger technique. Since the data series is short, this may be impor-tant. Second, the Prest technique utilizes more information than theSinger technique. Even small discretionary changes (those changingrevenue three percent or less) are incorporated into the Presttechnique while the Singer technique only accounted for discretionaryrevenue changes greater than three percent. Finally, as pointed outearlier, the coefficients of the dummy variables using the Singer-11-Table 4 Elasticities of Major Ivorian TaxesUsing Singer Technique, 1970-79Tax c c R D.W.All taxes -1.354** .963** .997 1.742Excise taxes -1.697** .634** .854 1.768Gas tax -2.603** .664** .951 2.716Export tax 1.407 .241 .846 2.894**Signif icant at the .99 confidence level.-12-technique were never significantly different from zero. While thiswas probably due to multicollinearity , it tends to reduce confidencein the model.IV. ConclusionsIn this study, two techniques for estimating elasticities wereapplied to tax revenue data from the Ivory Coast to determine theelasticities of the major Ivorian taxes. In general, the most elastictax is the value added tax, followed by total consumption taxes andimport taxes. The least elastic tax is the export tax followed byexcise taxes. Overall elasticity of Ivorian taxes is .961 meaningthat tax receipts grow at a slightly lower rate than GDP.These results are important for policy purposes. An elastic taxsystem is desirable in a developing economy because it means that taxreceipts will grow automatically with growing income without the need9for politically sensitive increases in tax rates. As per capitaincome increases with economic development, the demand for governmentgoods and services such as transportation, communication, and generalgovernment administration services also increases. Add to thisincreasing government demand for funds to finance development relatedprojects like education and agricultural extension, and the benefitsof an elastic tax system become evident.Since elasticity is an important element of taxation in a develop-ing economy, it is crucial that policy makers be able to identifythose taxes which are elastic and those which are inelastic. Increas-ing the overall elasticity of the tax system involves utilizing more-13-heavily those taxes which are most elastic. Further, the elasticityof individual taxes can be increased by certain measures. One is byimproved administration. Taxes which are better administered tend tobe more elastic. Another measure is to convert specific excise taxesto ad valorem taxes. Since an ad valorem tax applies a rate to thebase, revenues from ad valorem taxes tend to grow with the economywithout the need for discretionary increases.The techniques of this study could be readily extended to thestudy of taxes in other developing economies. The results of thisstudy suggest some preference for the Prest technique over the Singertechnique although further study is necessary to explore this issue.As longer data series become available for developing economies,further research in this area should be rewarding.-14-FootnotesFor a description of the Ivorian value added tax and its opera-tion, see Moise Kourooue Koffi, La Taxe sur la Valuer Ajoutee dans laDevelopment de la Cote d'lvoire,Nouvelles Editions Africaines,Abidjan, 1981.2See Arthur Anderson and Company, A Guide to Taxation in theIvory Coast , April, 1982, for further details.3Alan R. Prest, "The Sensitivity of the Yield of Personal IncomeTax in the United Kingdom," The Economic Journal , vol. 72 (1962), pp.576-96.4See Charles Y. Mansfield, "Elasticity and Buoyancy of a TaxSystem: A Method Applied to Paraguay," IMF Staff Papers,vol. 26, no.2 (1972), pp. 425-426.Neil M. Singer, "The Use of Dummy Variables in Estimating theIncome Elasticity of State Income Tax Revenues," National Tax Journal,vol. 21, no. 2 (1968), pp. 200-204.The data were obtained from International Monetary Fund, Analyseet Programmation Financieres : Application a la Co^te d'lvoire,Washington, D.C. (1984), Table 1, p. 222. An error in the data re-sulting in a nine billion CFA understatement of excise taxes, consump-tion taxes, and total tax receipts in 1977 was corrected. Estimatesof the discretionary revenue changes were obtained from Table 2, p.231, in the same source.According to a Durbin-Watson two-tail test, the hypothesis of noautocorrelation was rejected at the .05 level for the profits tax and-15-the excise taxes. The test was inconclusive for the income andprofits taxes and for export taxes.QThe three percent criterion was chosen arbitrarily so as tocapture significant discretionary revenue changes without generatingtoo many dummy variables in any one equation. Two dummies were addedto the all taxes equation (1973 and 1976), two to the excise equation(1972 and 1973), three to the gas tax equation (1972, 1973, and 1978),and one to the export tax equation (1976).9John F. Due, Government Finance , Richard D. Irwin, Inc.:Homewood, IL, 1981, p. 550.Stephen R. Lewis, Taxation for Development , Oxford UniversityPress: New York, 1984, p. 34.D/67HECKMAN J-.IBINDERY INC. |S|JUN95

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