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Investigating Tax Thresholds to Help Developing Countries Increase Economic Growth

April 18, 2017

Developing countries need. They need an educated labor force, reliable infrastructure, access to healthcare and other fundamental projects to grow their economies. In order to undertake these goals, first and foremost, they need money.

"For developing countries, there's no money to fund education, which is fundamental to economic growth," Assistant Professor of Economics Lourenço Paz said.

Most developing countries rely on revenue from import tariffs for their economies. In contrast, most developed countries rely on a value-added tax—taxes imposed on every level of the production chain. It's similar to the sales tax in retail stores in the U.S., but instead of being taxed at the end of the supply chain, each stage of production or distribution is taxed.

Although import tariffs are easily collected and provide enough revenue, they reduce economic growth more than other types of taxes. So at the prompting of organizations like the International Monetary Fund and World Bank, several developing countries replaced import tariffs by a value-added tax. But when those countries introduced the new tax to generate government revenue, it didn't work. In fact, the countries received less revenue than that generated by the import tariffs.

The problem is the value-added tax is a much more complex system than import tariffs, and it's more difficult to enforce. Auditors could seek out large firms to collect taxes, but smaller firms could more easily evade the new tax system. So Paz, who began working at Baylor in August 2015, sought a way for developing countries to overcome these problems.

Paz decided to investigate how countries could set a threshold to determine which firms are worthwhile to tax and which aren't.

"Nobody ever thought of changing the threshold instead of the tax rate before," he said. "My goal is to bring attention to this."

In his article, "The Welfare Impacts of a Revenue-Neutral Switch from Tariffs to VAT with Intermediate Inputs and a VAT Threshold," which was published in The Journal of International Trade and Economic Development, Paz uses numerical simulation to illustrate how changes in the value-added tax threshold could positively affect the economies of developing countries.

"I was expecting the threshold would bring small gains, but after simulations, it became clear that gains can be reasonable," he said. "It's something that deserves recognition."

Paz hopes his research will help provide the resources to spark change and economic growth in countries like his native Brazil.

"I hope policy makers put more thought on determining these thresholds. It's something that can't be overlooked," he said. "It's hard, but it's important."

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