September 25, 2020/IMFBlog
The COVID-19 shocks are proving to be especially challenging for fragile states. Pre-COVID, fiscal revenues were low in such countries and governments were struggling to raise them. Now, COVID-19 is hitting them hard and fiscal revenues are falling. Once the pandemic abates, restoring and further enhancing tax collection is even more important to secure debt sustainability, facilitate the post-COVID-19 recovery, and meet development financing needs in order to meet the Sustainable Development Goals. This is a formidable challenge. However, our new staff research finds that achieving sizable gains in tax collection in fragile environments is not “mission impossible.”
As our chart shows, four fragile states (Liberia, Malawi, Nepal, and Solomon Islands) achieved sizable increases in tax revenues over a decade—by between 7 and 20 percentage points of GDP. Most of these countries had introduced tax reforms when their tax revenues were far below the average for fragile states, but each went on to exceed the average, with Nepal and Solomon Islands doing so by a wide margin.
These experiences emphasize the importance of sustained tax reform efforts. In these cases, tax reforms were pursued over extended periods of time to achieve long-lasting, sizable gains. While this protracted approach may typically require political stability in order to ensure the continuity of tax reforms, it can also be achieved when administrations change, for example as we saw in Malawi.
These experiences also underscore the following lessons for tax revenue reforms in fragile states:
- Two-handed approach. Ensuring stable tax revenue yields over time requires both well-designed tax systems and effective approaches to revenue administration. In Liberia and Nepal, we found that using multiple tax policy instruments helped to boost tax collection (for instance, reducing tax exemptions, raising excise taxes, and increasing the VAT threshold).
- Potential source. Fairly targeting high potential sectors and areas—which should contribute significantly to tax revenues—can raise funds and promote fairness. Such sectors included the logging sector in the Solomon Islands and consumption (from large remittance receipts) in Nepal.
- Quick and strategic. Taking immediate reform steps can address pressing needs and build momentum, while a medium-term strategy can help to properly sequence reform measures. The reform steps, with immediate effects, could include reforming indirect taxes on goods and services, curbing exemptions, establishing a Large Taxpayers Office, and enhancing risk-based audits.
- Political commitment and international support. Sustained tax reform efforts over a long period requires strong political commitment supported by international partners. In the episodes we studied, tax reforms were often pursued with strong political will—for instance in facilitating coordination across agencies—while capacity building support from international partners also played a vital role. It is important to note, however, that political commitment is a necessary but not a sufficient condition for successful tax reform.