Information technology and fiscal capacity in a developing country:

evidence from Ethiopia

Merima AliCHR Michelsen Institute

Abdulaziz B. ShifaMaxwell School, Syracuse University

Abebe ShimelesAfrican Development Bank

Firew WoldeyesEthiopian Development Research Institute

Introduction

• A limited fiscal capacity of the state has received increased attention as an important constraint to economic development.

• In the year 2006, the average GDP share of government revenue in low income countries was 12.1%. For high income OECD countries, it was 25.2%

Introduction(contd.)

• Building fiscal capacity is not a costless endeavor.

• Tax enforcement requires gathering detailed earning information on large number of tax payers.

• The advance in information technology (IT) offers a cheaper possibility to gather and analyze large amount of data on tax payers.

Introduction (contd.)

• Over the past decades, “reform efforts in tax administration in developing countries have generally centered on IT”,Bird and Zolt (2008).

• Nevertheless, there has been little, if any, systematic empirical evidence on the impact of those reforms.

Objective of the study

• Provide evidence on the impact of usingelectronic sales registry machine (ESRM) on taxcompliance.

• We look at the impact of ESRM on the amountof the value added tax (VAT) paid by firms.

• We use administrative firm level panel data onlarge number of business tax payers in Ethiopia.

Electronic Sales Registry Machine (ESRM)

• Starting in 2008, the Ethiopian Revenue and Customs Authority (ERCA) required several businesses to use ESRM.

Electronic Sales Registry Machine (contd.)

• The machines register sales and issue receipts (print out of an electronic receipt).

• ESRMs are connected, through a general packet radio service, to the central data base of ERCA providing real-time data on eachtransaction.

• This has enabled ERCA to monitor reportedrevenues of firms on a day-to-day basis.

Electronic Sales Registry Machine (contd.)

• Harsh legal punishments have been enacted to discourage failure to issue the electronic receipts.

• ERCA initially targeted relatively large tax payers for ESRM use and gradually expanded the implementation to smaller firms.

Number of VAT payers and ESRM users (`000) thousands

Background to taxation in Ethiopia

Government revenue and expenditure as percentage of GDP

(2001-2011)

Government tax revenue by source (percent of total tax revenue)

Background to taxation in Ethiopia (contd.)

Background to taxation in Ethiopia (contd.)

• Several reforms to improve the tax system have been implemented that can be categorized into two broad aspects:

(1) introducing new taxes to broaden the domestic tax base: (the introduction of VAT in 2003).

(2) improving the administrative capacity of thetax authority (greater use of IT in tax administration).

Introduction of VAT

• Introduced in 2003, the VAT is the single largest component of domestic indirect tax.

• Over the past five years, VAT contributed nearly half of the indirect domestic tax and 20 percent of the total domestic tax.

VAT as percentage of total domestic tax revenue

Number of VAT payers and ESRM users (`000) thousands

Data• Our dataset contains the entire set of firms in

ERCA’s database.

• Monthly unbalanced panel observations on nearly all of the tax payers – consisting of about 85 thousands firms.

• The data has information on amount of VAT and ESRM use (the date)

• The data covers the period from January 2003 –when the VAT was introduced in Ethiopia – to July 2014.

Empricial Results• Our econometric approach involves comparison

of taxes before and after the ESRM use.

• We limit our analysis to those tax payers that have paid VAT both before and after using ESRM.

• We also exclude few firms that are owned by the government.

• This leaves us with 33,158 firms and 738,604

observations for the econometric analysis.

Comparison of VAT per firm between ESRM users versus non-users (in 2003 prices, ‘000 Birr).

Simple mean comparision

Average monthly VAT = 57,866 Birr

Pre-ESRM use = 50,700 Birr

Post-ESRM use = 63,300 Birr

• the simple mean comparison doesn’t take care of several relevant concerns.

- overall policy changes may confound with

introduction of the ESRM use.

- part of the change is likely to come from time

trend from confounding facts (such as inflation and

firm growth).

Regression specification

logTaxj,t = ∑ βzIj,t,z+ µ j+ψt+ ε j,tz∈Z

• Taxj,t is the tax paid by firm j in time t

• z∈ Z= {z, z+ 1, . . . ,−2,−1, 1, 2, . . . , z̄ − 1, z̄ }

denotes the number of periods (quarters) around the

beginning of ESRM use. For periods preceding/following

ESRM use

• I j,t,z is an indicator variable that equals one if the number

of periods around ESRM use for firm j in time t equals z;

otherwise, I j,t,z equals zero.

• µ j andψt are firm and time fixed effects; ε j,t is the error

term.

Impact of ESRM on log VAT(estimated βz’s and 95% CI)

Heterogeneous effects

• Looking at the impact of ESRM use betweenfirms that are likely to have different costs ofevasion.

• Hypothesis: those firms that have a higher cost of evasion, and had not been evading, even prior to ESRM use should not be affected by its introduction.

Heterogeneous effects

Potential differences in the likelihood of evasion across different ownership structure of firms;

(i) Personally owned firms: usually family run businesses

(ii) Institutionally owned firms: such as shareholders and cooperatives

Heterogeneous effects (contd.)

• Institutionally owned firm are typically large in size and owned by larger number of owners (shareholders)

• The managers of share companies are not necessarily the owners.

• An agency relationship that necessitates the need for availability of verifiable information to shareholders about the performance of the managers.

• Their relatively larger size makes them a valuable revenue source for the government.

Heterogeneous effects (contd.)

• In institutionally owned firm’s, its creditworthiness in contractual obligations is likely to depend on its ability to present a legally verifiable record on its financial state.

• The same records of firm’s, creditworthiness can be used by the tax authority to trace the firm’s revenue

Heterogeneous effects (contd.)

Robustness checks

• Robustness checks done that pertain to the following major concerns with the forgone regressions.

1. The above specification may not completely address biases that arise from time varying factors that also increase a firm’s revenue/sale

• However, this may not be a concern due to two reasons

The selection criteria used by ERCA are focused on firmcharacteristics that are unlikely to fluctuate over time.

Analysis of trends prior to the ESRM use suggest that changes in tax payments after ESRM use are not associatedwith differences that existed among firms prior to ESRM use.

Trends prior to ESRM use: mean log VAT and 95% confidence interval

Robustness checks (contd.)

2. Differential time trend

a) across different regions

(if the ESRM use is expanded across regions in a non-random pattern, the differential time trend across regions may bias our estimated effect)

-We run the regressions allowing for district-specific time effects (for 81 districts).

-The R-Square increases substantially but the results remain the same

Robustness checks (contd.)

b) Across sectors (rather than regions)

- There are 193 types of sectors in the data

- The results remain the same after controlling for sector specific fixed effects

3. Change in the composition of our sample

- not all of the firms in our sample are observed during the entire period

Robustness checks (contd.)

• Part of the observed dynamics in the periods around the beginning of ESRM use could be a result of this change in composition of firms, rather than the actual effect of ESRM use.

• We run the regression including only the firms that are observed for at least a year and two years before and after the ESRM use.

• The results remain the same

Conclusion

• We document the first empirical evidences on the impact of ESRM on tax compliance using micro data from Ethiopia.

- tax payments by firms increase in the aftermathof the ESRM use.

- the effect is driven primarily by personally ownedfirms, which we believe are more likely to evadetaxes.

This result suggests that the ESRM use minimized evasion among firms that are more likely to evade taxes.

Conclusion (contd.)

• The evidences point to a possible positive contribution of the IT revolution to fiscal capacity in developing countries.

• However, this conclusion comes with an important qualification.

• We estimated the effect on firms that are already registered as tax payers – a relatively small fraction of the firms in the country.

Conclusion (contd.)

• If the increased enforcement via ESRM use forces firm to operate underground, the revenue gains from ESRM use may be weakened due to increased informality.

• The extent to which increased enforcement through ESRM use leads to a higher level of informality should be an interesting agenda for future research.