Final
The Quality of Governance and Tax Effort: Evidence from
Developed and Developing Countries

Research Report prepared forCase Study 5140143: International Political Economy

Submitted To:
Professor Nobuhiro HiwatariInstitute of Social Science andGraduate School of Public Policy
The University of Tokyo

Prepared By:
Mohammad Iqbal Hossain
Student ID: 51-138214
MPP/IP, First Year Student

Graduate School of Public Policy (GraSSP)The University of Tokyo
Tokyo 113-0033, Japan
July 2014

Contents
Section 1: Introduction ............................................................................................................... 4
Section 2: Literature review....................................................................................................... 9
Section 3: Methodology of the Study .................................................................................... 12
3.1 Institutional Capacity: Construction ........................................................................................ 13
3.2 Concept of Corruption ............................................................................................................... 24

Section 4: Data and Estimation Procedure ........................................................................... 14
4.1 Dependent variable .................................................................................................................... 14
4.2 Structural or economic factor .................................................................................................... 14
4.3 Institutional factors ..................................................................................................................... 15
4.3 Estimation Technique................................................................................................................. 16

Section 5: Regression results and findings .......................................................................... 16
Section 6: Conclusions and Policy Suggetions .................................................................... 23
References ................................................................................................................................................. 24
Appendix ................................................................................................................................................... 26

List of Tables

Table 1.1: Summary statistics-within and between variation for panel data ................................. 19
Table 1.2: Comparing estimators for panel data model: equation 1 ............................................... 20
Table 1.3: Comparing estimators for panel data model: equation 2 ............................................... 21
Table 1.4: Fixed effect model estimation: the impact of governance in sample countries ............ 22
Appendix Table 1: Summary of previous studies on tax efforts .................................................... 26
Appendix Table 2: Variable descriptions and sources .................................................................... 29
Appendix Table 3: List of sample countries ..................................................................................... 29
Appendix 4: Worldwide government indicators ............................................................................. 30
Appendix 5: Muilti-dimensional Poverty Index .............................................................................. 30

List of Figures
Figure 1.1: Tax efforts and HDI 2012 of 105 countries ....................................................................... 6
Figure 1.2: Revenues from personal income taxes (as % of GDP), 2008-09 ..................................... 7
Figure 1.3: Tax efforts and poverty (mpi) of developping countries, 2012 ...................................... 8
Figure 1.4: Positive linear association between tax efforts and institutional capacity .................. 17
Figure 1.5: Positive linear association between tax efforts and control of corruption .................. 18

	
  

2	
  

Acronyms and Abbreviations
GDP

Gross Domestic Product

GNP

Gross National Product

GMM

Generalized Method of Moments

HDI

Human Development Index

HDR

Human Development Report

IMF

International Monetary Fund

MPI

Multi-dimensional Poverty Index

OLS

Ordinary Least Square

UNDP

United Nations Development Program

USAID

United States Agency for International Development

WDI

World Development Indicators

WGI

Worldwide Government Indicators

	
  

3	
  

The Quality of Governance and Tax Effort: Evidence from
Developed and Developing Countries
Mohammd Iqbal Hossain
Graduate School of Public Policy, The University of Tokyo
Abstract: The paper argues that the quality of the governance is an important demand side
determinant factor for more adequate level of tax effort in developing countries anddeveloped countries. The study will analyze the effect of the quality of governance(institutional capacity and control of corruption) on tax effort using panel data set for 55
developed and developing countries during 2002- 2012. The collected data was analyzed
using fixed effect and random effect model. The study result indicates that governancequality matters for tax revenue collection and findings support the hypothesis thatwillingness to pay taxes depends on the better quality of government i.e. higher
institutional capacity and lower corruption enhances more tax revenue in the economy.

Keyword: Tax effort, corruption, governance, institution, random and fixed effect model,
poverty, development

Section 1. Introduction
Taxes are inevitable since citizens expect from govt. to provide various goods andservices. Wagner’s law imply that economic development is associated with an increased
request for public goods and services, which need to be financed inter alia by increasing
tax revenue since the demand for public services is income elastic (Tanzi, 1987).
Developing country requires more expenditure on public infrastructure, health services,education as they can grow and reduce poverty and therefore, they requires to increase
their tax effort (tax revenue as percentage of GDP). A low tax efforts is a jointly
consequences of both supply side and demand side factors. The supply side factors of tax
effort includes tax base like per capita income, composition of the economy, economic
activities. Most of the earlier studies emphasis this supply side capacity to increase tax
effort of a developing country (Bird, Martinez and Torgler, 2008).
Developing countries are generally unable to collect potential amount of revenue throughtaxation due to several governance problems. Begum, L. (2007) found that developing
countries having low tax effort (less than unity) are not utilizing their full capacity of tax
	
  

4	
  

revenue, and they can reduce the budgetary imbalance through raising tax revenue. Lackof institutional capacity and exercise public power for private gain i.e. corruption are
main culprit for this low tax effort.
Tax-GDP ratio as a measure of tax effort is a static measure, which provides a view of tax
performance in terms of degree of use of taxable capacity at a given time. The three
general perceptions for low Tax-GDP ratio, first: narrow tax base due to dominance ofagriculture and informal sectors in the economy, low-income per capita and high poverty
rate; second, revenue looses from the on-going tax reforms especially the process of tradeliberalization-major reduction of import tariff; and, third, low potentially of tax
administration and growing practice of tax evasion and corruption.
When we say a country has low tax efforts? It’s an important question. In the literature
we can found some academic evidence. “Will underdeveloped countries learn to tax?”
asked Nicholas Kaldor,1963, fifty year ago. Underlying assumption of question: A
country wishes to become “developed” requires more than 10-15 percent tax-gdp ratio
found in many developing countries. Sir Arthur Lewis (Martin and Lewis 1956) said toprovide average standard of services a govt. of underdeveloped country needs to raise tax
revenue of about 17-19 percent of GNP.
The primary purpose of the taxation is to finance government expenditure and to
redistribute the wealth, which increases the development of the country (Ola, 2001,
Jhingan, 2004, Musgrave and Musgrave, 2004, Bhartia, 2009). Government needs tocollect taxes in order to provide public goods, such as infrastructure, education, publichealth, securities etc where the market economy fails. Musgrave and Musgrave (2004)
stated that the tax revenue has two effects: reduce income inequality and ensure theefficient use of the resources, which he called micro effects, and second, the effects on
the level of capacity output, employment, prices, and growth called macro effect.
Government can use of tax as an instrument of fiscal policy to boost up economic growth,
although this tools are less reliable in the less developed countries due to the diminishingpattern of revenue generation. On the other hand, developed countries have influenced

	
  

5	
  

their economic development through tax revenue such as Canada, United States,
Netherland, United Kingdom (Oluba 2008). Worlu and Nkoro (2012) showed that tax
revenue stimulates economic growth through infrastructural development.
If we linking the tax efforts to the Human Development Index (HDI)1 for 105 developed
and developing countries in 2012, we can found there is a positive association among thetwo (Figure 1.1).

.4

.6

.8

1

Figure 1.1: Tax efforts and HDI 2012 of 105 countries

0

10

20
TE
95% CI
HDI

30

40

Fitted values

Source: UNDP and WDI, 2012

The developing countries need to achieve in progressive and redistributive taxes in orderto ensure public services, such as education and health for all (Itriago, Deborah 2011).
Figure 1.2 shows the fact that in developing countries revenue from income tax is still
excessively low compared to OECD countries (Adopted from Itriago, Deborah 2011). As
Figure shows, the revenue from personal income taxes for low-income countries accounts
for less than 2 per cent of GDP.

	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  
1	
  HDI	  is	
  a composite statistic of life expectancy, education, and income indices used to rank countries into

	
  

6	
  

Figure 1.2: Revenues from personal income taxes (as % of GDP), 2008-09

Source: Adopted from Itriago, Deborah 2011:(USAID (United States Agency for International
Development) Fiscal Reform Project 2008-09 (www.collectingtaxes.net, accessed July 2010)

As noted by IMF (cited in TJN, 2012): “Developing countries must be able to raise therevenues required to finance the services demanded by their citizens and theinfrastructure (physical and social) that will enable them to move out of poverty.
Taxation will play the key role in this revenue mobilization . . . . .”Although recent improvements in tax efforts, half of sub-Saharan African countries still
generate less than 15% of their GDP in tax revenues, as against an average of around
35% in OECD countries and 23% in Latin America. This makes difficult for the country
to reduce poverty though the development activities.2 There is a negative association
between the tax efforts and Multi-dimensional poverty index (MPI)3 i.e. the higher the
tax efforts in a developing countries has lower rate of poverty or vice versa (Figure 1.3).

	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  
2http://www.oecdobserver.org/news/archivestory.php/aid/3134/Tax_for_development.html#sthash.k54r4Ki1.dpuf

	
  Multidimensional poverty is made up of several factors that constitute poor people’s experience of deprivation – suchas poor health, lack of education, inadequate living standard, lack of income (as one of several factors considered),disempowerment, poor quality of work and threat from violence.
3

	
  

7	
  

-20

0

20

40

60

80

Figure 1.3: Tax efforts and Poverty (MPI) of developing countries, 2012

0

10

20
TE
95% CI
Poverty

30

40

Fitted values

Source: World Bank, 2013

In this study we analyze the effects of the demand side and supply side effects on the tax
efforts in the 55 developed and developing countries, using panel data set from the period
2002-2012. The most important contribution of this study is to extend the literature(model presented by Imran and Jacobs 2007) by using supply side i.e. the quality of
governance that can affect tax efforts. The main purpose of this paper is to justify
whether the quality of governance (better institution and low corruption) leads to a higher
tax efforts. The first hypothesis focuses on better institutions (expecting positive impact)
while the second one will lead explore the impact of corruption (expecting negative
impact).
The rest of the paper is organized as follows. In section 2, we review some relevant
studies, which provide the theoretical and empirical background for the study. In section
3, we explain the methodology. In section 4 explains the data and variable constructionand estimation technique. Section 5 comprises of the study results and discussions of thestudy. In section 6 we conclude the study with some policy suggestions.

	
  

8	
  

Section 2. Literature Review
In the public service, the incentives of being engaged in corrupt behavior has two fold:
first, government official who wanted to be enrich themselves by taking bribe andsecond, bribe payers who wanted to obtain undue benefits as tax evasion. The degree ofthe complexity of the tax system encourages the public official to exercise theiradministrative power and increase the corruption (Ajaz and Ahmed 2010).
Sandmo (2004) uses the concept of tax evasion in the following words. "Tax evasion is aviolation of the law: When the taxpayer refrains from reporting income from labour orcapital which is in principal taxable, he engages in an illegal activity that makes him
liable to administrative or legal action from the authorities”
What matters is not only how high taxes are (revenue adequacy), but also how the tax
level has been chosen, how the taxes are imposed, and how the funds thus raised areused. Taxation matters are, in democratic states, resolved through political channels.
Indeed, history suggests that the need to secure an adequate degree of consensus from thetaxed is one of the principal ways in which, over the centuries, democratic institutions
have spread. State legitimacy thus rests to a considerable extent on citizens’ ‘quasivoluntary compliance’ (Levi 1988) with respect to taxation. To secure such compliance,
tax systems must, over time, in some sense represent the basic values of at least aminimum supporting coalition of the population. Thus, the key aim of the paper is toexplain whether better institutions lead to a higher tax effort. The first hypothesis focuseson voice and accountability while the second one will explore the impact of corruption.
Good governance brings good tax system and state legitimacy, taxpayers' willingness to
pay tax, and the effectiveness of tax administration are the main pillars for the good tax
system. Phillips and Sandali (2008) describe the relationship between governance and tax
reforms. The study explains that three key dynamics reflects the relationship between
governance, taxation and investment climate. The better governance can design good andinvestment friendly tax system, which foster the economic growth.

	
  

9	
  

The quality of the governance is crucial for proper planning and efficient revenue
generation. When the tax evasion and corruption of public officials is a generalperception than it negatively effects on tax revenue and as well as economic growth anddevelopment (Ajaz and Ahmed 2010). A more legitimate and responsive state is theprecondition for a more adequate level of tax effort in developing countries and highincome countries. For poor countries tax rate raises are not efficient to increase tax
revenue, more feasible solution for them to improve their governing institutions (Bird, R.
M., Jorge M. V., and B. Torgler, 2008). By improving the governances structure i.e.
institutions high-income countries can increase their tax revenue, so tax efforts of acountry is highly responsive to governance structure or institution.
Hypothesis 1: The presence of an effective and efficient government is an essential
precondition for a more adequate tax system. If taxpayers perceive that the institutions(civil, law and regulatory bodies) are capable and independent enough from politicalinfluence to address their interests (preferences) having meaningful ‘good governance’ ismotivates the state their willingness to contribute increase. The study assume that if acountry “A” has better has good governance system than country “B” than it is expectedthat country “A” have more tax efforts than country “B”.
With a good governance the country offers the people a good tax system– better in thesense of giving the people what they want- which encourage to the people to pay taxes
for better public services.
Some studies have found that institutional factors determine the revenue performance ofan economy. Bird, et al. (2004) showed that factors such as corruption, rule of law, entry
regulations is important determinant of tax revenue. Gupta (2007) found that corruption
has a significantly negative effect on tax revenue. Ajaz and Ahmed (2010) investigate therelationship between corruption and tax efforts using panel data set for 25 developing
countries during 1990- 2005. The GMM regression results suggest that corruption has
adverse effect on tax collection, while good governance contributes to better performancein tax collection.

	
  

10	
  

Tanzi and Dvoodi (1997) found evidence that countries with high level of corruption tend
to have low tax revenue which imply that some portion of the taxes paid by taxpayers arediverted away. Tanzi (1999) suggested separation of tax collection and receiver authority
i.e. taxes should be collected by the tax administrators and taxes should received by thetreasury.
Hypothesis 2: In order to explain the country level variation in the tax efforts we have totake into consideration on the degree of corruption exercise by the institutions. If the
taxpayers believe that they live in a state where institutions are corrupt and control ofcorruption is low, the willingness to contribute decrease. The study assume that if acountry “A” has better has less corrupt public sector than country “B” than it isexpected that country “A” have more tax efforts than country “B”.
In case of the developing countries corruption is widespread phenomena and it shirks thecountry’s revenue so the state failed to full the social obligation and its creates negative
impression from the public which again goes like vicious circle.

Literature shows that

more than 50 percent of tax revenue goes uncollected because of fiscal corruption and tax
evasion in the developing countries (Richupan, 1984; Alm,et al, 1991; Bird, 1990, 1991;
and Krugman, et al, 1992).

	
  

11	
  

Section 3: Methodology
Efficiency of the government determines the revenue collection. Good governanceprovides an adequate tax system, improved tax administration, a better macroeconomic
policy, which generates more revenues (Ajaz and Ahmed, 2010). Benno (2003) showed
direct democratic rights, local autonomy, trust in government and courts and legal system
has a positive and significant effect on tax morale. To test weather the quality of thegovernance fosters tax efforts of the South and East Asian countries, the following model
will be used:
Tax effort= Government quality (demand side) + Economic control variables (supply
side)
𝑇𝐸!" = 𝛼 +𝛽! 𝐺𝑂𝑉𝑄!" + 𝛽! 𝐸𝑥𝑝!" +𝛽! 𝑂𝑝𝑒𝑛!" +𝛽! 𝑀2!" +𝛽! 𝑈𝑟𝑏𝑎𝑛!" +𝜇! + ∈!"#
𝑇𝐸!" = 𝛼 +𝛽! 𝐼𝑛𝑠𝑡!" +𝛽! 𝐶𝑜𝑟𝑟!" + 𝛽! 𝐸𝑥𝑝!" +𝛽! 𝑂𝑝𝑒𝑛!" +𝛽! 𝑀2!" +𝛽! 𝑈𝑟𝑏𝑎𝑛!" +𝜇! + ∈!"#
where i indexes the countries in the sample, t refers to a year; 𝑇𝐸!" indicates the country’slevel of tax effort measured as the tax revenue to GDP ratio; 𝐺𝑂𝑉𝑄!" are indicators for
institutional capacity and control of corruption; 𝐸𝑥𝑝!" represents the annual government
expenditure as percent of GDP; 𝑂𝑝𝑒𝑛!" define as export plus import as ratio of GDP;
𝑀2!" stands for share of broad money as share of GDP; 𝑈𝑟𝑏𝑎𝑛!" represents share of
population live in urban areas; 𝜇! stands for country effect and ∈!"# is an error term.
Suppose country A has better institution with less corruption than country B with same
economic structure. It is expected that country A can effectively exercise its economic
policy to collect more tax, and the people in country A suppose that government agencies
are quite efficient to find out the underestimate of the tax return so they have tendency to
tax evasion. In this paper, I am expecting positive relationship with institution and tax
efforts.
The previous year spending behavior highly influenced the current year expenditure andto meet up the expenditure the government has to collect more tax. It is expected thatthose countries be expected to spend more they will collect more tax.

	
  

12	
  

The important traditional determinants in the literature of the tax efforts are controllingthe economic structure of an economy. The trade taxes are important source of revenue
for the less developed countries because for the government it is easier to collect than theincome taxes. The tax effort is expected to positive relation to the degree of openness ofthe economy.
The sectorial composition of the domestic economy also influences the degree of tax
effort. To tax on traditional sector like agriculture are more difficult than taxed on
manufacturing or service sectors. Some researchers argue that to tax on agricultural
sector are not so difficult (Bahl 2003), and as public sector activities are city based so thislarge sector demands lower public intervention (Tanzi 1992). Furthermore, somecountries exempt agriculture activities from taxes to favor a large group of people.
The urbanization creates more demands for public goods and services, and the as thedemands increase its also raise the price of the public goods i.e. tax. It is expected that acountry with higher urbanization will generate more taxes than lower urbanization
country. Growth in monetization is represented by M2, also influences significantly andpositively the buoyancy of the indirect taxes. When the people of a country transact its
economic transaction more through the banking channels its easier to tax on those
activities than manual or cash transaction. It also expected that there is a positive
relationship between the broad money and the tax efforts.
3.1 Institutional Capacity: Construction•

Government Effectiveness captures perceptions of the quality of public services,the quality of the civil service and the degree of its independence from politicalpressures, the quality of policy formulation and implementation, and thecredibility of the government's commitment to such policies.

•

Rule of Law captures perceptions of the extent to which agents have confidence
in and abide by the rules of society, and in particular the quality of contract

	
  

13	
  

enforcement, property rights, the police, and the courts, as well as the likelihoodof crime and violence.
•

Regulatory Quality captures perceptions of the ability of the government toformulate and implement sound policies and regulations that permit and promoteprivate sector development

Institutional capacity=1/3(government effectiveness+ rule of law+ regulatory quality)= higher value represent strong institutional capacity
3.2 Control of corruption: Control of Corruption captures perceptions of the extent towhich public power is exercised for private gain, including both petty and grand forms ofcorruption, as well as "capture" of the state by elites and private interests. All theindicators value range from -2.5 to 2.5 and they also transformed into percentile form,
which ranges from 0 to 100. Higher the value the country has lower corruption in theeconomySection 4: Data and Estimation Procedure
This section explains the list of indicators are included in this analysis and also the how
this variable are constructed. First, we explain about the dependent variable; second, we
explain the list of independent variable, in which both the economic control variables andinstitutional variables are included.
4.1 Dependent Variable
Dependent variable is tax effort (tax revenue ratio to GDP): as an adequate volume ofgovernment revenue is essential for public expenditure and economic growth, the ratio oftax revenue to GDP has been used to measure and judge the success of a country's fiscal
management.
4.2 Structural or economic factors
The expenditure as percentage of GDP indicates the capacity of the government both on
expenditure and revenue perspective. This expenditure is equivalent to per years
	
  

14	
  

government budget, and expressed as ratio of GDP. We used the economic outcome
measure of trade openness, which is export plus imports divided by GDP, all measured atcurrent prices in USD. The M2 or broad money refers the currency in circulation plus
deposit divided by the GDP, all measures at current in USD. The people living in theurban area divided by the total population in the country is referred urbanization.
4.3 Institutional Factors
Corruption refers the abuse of public power for private benefit. It is captured by an index
that measures the extent to which bribes are generally expected by government officials
in relation to provide public service (Tanzi, 1998). The World Bank Research Instituteforms the Worldwide Governance Indicators (WGI), which consists of six aggregate
indicators of governance covering 200 countries, with cross-country data from 30
organizations. Measuring six dimensions of governance starting in 1996: Voice andAccountability, Political Stability and Absence of Violence/Terrorism, Government
Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption (for details
see appendix). The aggregate indicators are based on several hundred underlying
variables taken from a wide variety of existing data source. The data reflects the views on
governance of survey respondents and public, private, and NGO sector experts
worldwide.

The institution variable will be form as a weighted mean of government effectiveness,rule of law, and regulatory quality. On the other hand, Control of Corruption captures
perceptions of the extent to which public power is exercised for private gain, including
both petty and grand forms of corruption, as well as "capture" of the state by elites andprivate interests, this index will represents the corruption variable.
The study uses a panel dataset covering 55 developed and developing countries over a 11
years period: 2002-2012. The countries are chosen on the basis of availability of theeconomic and institutional data (see sample countries in appendix). All the data related toeconomic or control variables are taken from World Development Indicator (WDI), which

	
  

15	
  

data are widely used in the literature. Data related to corruption and institutional variables
data are constructed from the Worldwide Governance Indicators (WGI). The World Bank
start to collect WGI data from 1996, but they start to conduct this survey annually from2002. To avoid the missing data in this study used the data from 2002.
4.4 Estimation Technique
Endogenity arises when right hand side variable are correlated with the random error
term of the equation. Model uncertainty arises when we cannot fully capture thedeterminants of tax revenues. The problem of omitted variable bias and endogeneity
arises in Random Effects model. Exogeneity assumption in random effect models that theresiduals are independent of the covariates. In order to test for this form of endogeneity,
the Housman test (Hausman, 1978) is often used. This takes the form of a comparison
between the parameter estimates in both the fixed effect and the random effect model(Greene, 2012, Wooldridge, 2002). The Hausman test is regularly deployed as a test forwhether RE can be used, or whether FE estimation should be used instead (for example
Greene, 2012 p421). To avoid the problem of endogeneity, all higher-level variance iscontrolled out by the higher-level entities themselves (Allison, 2009).

Section 5: Regression results and Findings
We start our empirical findings to revisit the significance of the demand side
determinates of the tax efforts in the literature. The capacity to pay taxes depends on thelevel of development, and generally we expect a positive relationship among the level ofper capita income and the level of tax efforts. In this study, we drop the per capita income
variable as it has a high correlation with the government index. We may say that in thehigher level of development brings by good governance, through effective administration
with lower corruption.
In the traditional basic tax effort model that has ignored the role of demand factors in explaining
relative revenue performance. We use the Kaufmann, Kraay, and Mastruzzi (2003) data set tomeasure institutional capacity and corruption. All scores lie between –2.5 and 2.5, with higherscores corresponding to better governance.

	
  Because of high correlation (0.93) between16	  institutional capacity and control of corruption variable, I use these two sets of indexes inalternate estimations in equation 1 and 2.
The correlation between tax efforts and institutional capacity shows positive liner
association, which imply the first hypothesis. It is expected that those countries that havehigher institutional capacity may generates more tax revenues (Figure 1.4).

0

10

20

30

40

Figure 1.4: Positive linear association between tax effort and institutional capacity

0

20

40

60

80

100

ins_cap
Fitted values

tax_gdp

The control of corruption and tax efforts also has positive linear association which
implies lower the corruption of the public official expected to higher tax revenue. Thesealso support our second hypothesis that a country with lower corruption has more tax
revenue than a country that has higher corruption (Figure 1.5). This two correlationshows that the demand side determinants are relevant in explaining tax performance inthe developed and transition economies.

	
  

17	
  

0

10

20

30

40

Figure 1.5: Positive linear association between tax effort and control of corruption

0

20

40

60

80

100

corr
Fitted values

tax_gdp

We have panel data on tax efforts and we need to account for variation over time (within)
and across individuals (between). Tax effort is the dependent variable and exp_gdp,
openness, M2_gdp, urban, inst_cap, and cont_corr are independent variables. To analyze
the panel data we can use following estimators:•

Pooled OLS•

Between (if the between variation dominates)•

Fixed effects (within variation dominates)•

First differences•

Random effects

The id and t variables are not real variable, id shows the cross section dimension and tshows the time dimension of the data set. This two variable decides how to classify ourpanel data; it said that we have 55-observation 11 years data point starting from 2002 to
2012.
In the summary table 1.1 each variable have mean, standard deviation and min-max. The
standard deviations are gives in three categories: overall, between and within. The
between variation implies the variation of the same variable over time. On the other hand,within variation refers to the variable among the different countries in different time
periods. The mean of the tax_gdp variable is 16.9, the minimum is 7.0 and maximum is
	
  

18	
  

37.5. Lets see the overall variation is 6.1, if we see between and within variance- thewithin variation dominates. All the independent variable (except control of corruption)
are explained by within variation that's mean the variable vary across countries over time.
The control of corruption has more between than within variation among the observation
over time (Table 1.1). Therefore, the most of the variables variability in this data set canbe explained by the within variation.
Table 1.1: Summary Statistics-within and between variation for panel data
Variableidt

tax_gdp

exp_gdpm2_gdpopennessurban

ins_cap

Cont_corr	
  Variation
overallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithinoverallbetweenwithin

Mean
28.2

2007

16.9

22.6

61.9

81.1

53.5

53.3

50.9

Std. Dev.
16.0
16.1
0.0
3.2
3.3
0.0
6.1
0.9
6.0
8.7
1.2
8.6
40.0
4.1
39.8
35.6
3.6
35.5
22.5
1.0
22.5
23.1
0.5
23.1
26.8
26.4
5.9

Min
1
1
28.2
2002
2002
2007
7.0
15.2
7.2
7.6
21.2
7.3
11.9
55.6
15.2
29.0
74.9
28.6
12.5
52.1
13.7
7.8
52.4
8.7
2.4
10.1
12.5

Max
55
55
28.2
2012
2012
2007
37.5
18.0
36.7
53.7
24.5
52.6
247.8
67.1
243.5
256.0
85.9
259.1
100.0
55.1
101.4
99.7
53.9
99.5
100.0
99.7
71.0

19	
  

Table1.2: Comparing estimators for panel data model: Equation 1
Tax effort
Govt. Expenditure
M2_gdpOpenness
Urban pop
Institutional
Capacity
Constant
R-sq (within)
R-sq (between)
R-sq (overall)Sigma uSigma eRho
Observation

Pooled OLS

Within or Fixed effectRandom effect0.146**(0.0284)-0.0100**(0.0031)0.0134**(0.0049)
0.0285**(0.0093)0.169**(0.0077)
2.599**(0.477)0.188**(0.0285)-0.038**(0.0092)
0.029**(0.006)0.215**(0.055)0.138**(0.018)-6.27*(3.06)
0.24
0.62
0.58
4.855
1.705
0.890
583

0.187**(0.285)-0.025**(0.007)0.028**(0.005)0.062**(0.019)0.140**(0.014)
1.164(1.17)
0.23
0.72
0.67
3.037
1.705
0.760
583

0.70

583

Notes: Significance levels: * 0.01< p < 0.05, ** p < 0.01.

Results shows (Table 1.2) that higher values of expenditure, trade openness, urbanizationand institutional capacity are associated with higher values of tax efforts for all estimators
while the M2 or monetization has negatively influenced on tax efforts.
According to the pooled OLS, across individuals and over time, an additional unit ofinstitutional capacity improvement leads to 0.17 units of higher tax revenue. In within
regression, each additional unit of improvement of the institutional capacity above theaverage for an individual country leads to 0.14 unit higher tax revenue (Table 1.2). In 2ndmodel (Table 1.3), the control of corruption has expected positive sign with the tax
efforts, implies that as the government can increase control over the degree of corruption,
the tax revenue will increase more.

	
  

20	
  

Table 1.3: Comparing estimators for panel data model: Equation 2
Tax effort
Govt. Expenditure
M2_gdpOpenness
Urban pop
Control ofcorruption
Constant

Pooled OLS
0.173**(0.027)0.0007(0.003)0.0186**(0.0049)
0.0354**(0.0099)
0.131**(0.0053)
2.950**(0.487)

R-sq (within)
R-sq (between)
R-sq (overall)Sigma uSigma eRho
Observation

0.70

583

Within or Fixed
effectRandom effect0.2097**(0.029)-0.0355**(0.0094)
0.028**(0.006)0.212**(0.057)0.0585**(0.018)-2.195(3.149)
0.19
0.55
0.51
4.548
1.764
0.869
583

0.210**(0.0264)-0.0184*(0.0075)
0.028**(0.005)0.084**(0.0194)
0.078**(0.0106)
2.632*(1.149)
0.17
0.69
0.65
2.960
1.764
0.738
583

Notes: Significance levels: * 0.01< p < 0.05, ** p < 0.01.

Housman test: To test whether Random or Fixed effect model are appropriate.
Null: Random effect model is appropriate
Alt: Fixed effect model is appropriate
Equation 1:Institutional capacityb = consistent under Ho and Ha; obtained from xtreg
B = inconsistent under Ha, efficient under Ho; obtained from xtreg
chi2(5) = (b-B)'[(V_b-V_B)^(-1)](b-B) = 15.20
Prob>chi2 = 0.0095
We reject the null and we can accept that fixed effect model will be efficient for panel
regression.
Equation 2: Control of corruptionchi2(5) = (b-B)'[(V_b-V_B)^(-1)](b-B) = 26.72
Prob>chi2 = 0.0001
We reject the null and we can accept that fixed effect model will be efficient for panel
regression.

	
  

21	
  

The Hausman test shows significant differences between the coefficients for the fixed
effects and random effects model. Therefore, we need to use the fixed effects model.
Table 1.4: Fixed effect model estimation: the Impact of governance (institutional
capacity and control of corruption) in developed and developing countries
Tax effort
Govt. Expenditure
M2_gdpOpenness
Urban pop
Institutional
Capacity

Equation 1

Equation 20.1878**(0.0812)-0.0377(0.0094)
0.0298***(0.009)0.215**(0.0904)
0.0138**(0.0623)0.2097**(0.1008)-0.0355(0.0448)0.0281***(0.1002)0.2125**(0.0853)

Control of corruption
Constant
R-sq (within)
R-sq (between)
R-sq (overall)Sigma uSigma eRho
Observation-6.270(5.721)
0.24
0.62
0.58
4.855
1.705
0.890
583

0.0584*(0.0334)-2.195(4.583)
0.19
0.55
0.51
4.548
1.764
0.869
583

Notes: Significance levels: * 0.05 < p < 0.10, ** 0.01< p < 0.05, *** p < 0.01.

In the next step we explore the whether we also observe a robust relationship between
governance quality (institutional capacity and control of corruption) and tax effort in thedeveloped and developing countries. The results are reported in Table 1.4, we observedthat the demand side determinates are highly relevant to explaining the tax revenue
performance. The regression coefficient of institutional capacity and control of corruption
variable is positive and significant. Interestingly, institutional capacity has a stronger
impact on tax efforts than controlling of corruption. This result implies the conformity of
our earlier expectation. The study result indicates that governance quality matters for tax
revenue collection. These finding support the hypothesis that willingness to pay taxes
depends on the better quality of government i.e. higher institutional capacity and lower
corruption enhances more tax revenue in the economy.

	
  

22	
  

Section 6: Conclusion and Policy Implication
The ultimate conclusion of this paper is that a more capable institution and less corrupt
administration is likely an important precondition for more adequate level of tax efforts
in the developing and also in developed countries. The main contribution of this paper is
to show the quality of governance matter for tax revenue collection. The study results
suggest that institutional capacity and control of corruption has positive and significant
effect on tax effort i.e. good governance has a positive effect on tax system and revenue
collection.
The fixed effect model (robust) show that institutional capacity variables have significant
effect on tax effort. The results suggest that developing countries can improve their tax
performance through improving their institutional structure. In particular, an
improvement in institutional capacity will lead to higher tax efforts. The control ofcorruption coefficient is positive and so we can say if a country takes measures to control
corruption, which will enhance their tax effort. Efforts need to be made by thegovernment to make improvement to institutional capacity (effectiveness ofadministration, regulatory quality, rule of law and control the corruption in all level
especially in public service.

	
  

23	
  

References:
Ahmed, Q.M. (2010). Determinants of Tax Buoyancy: Empirical Evidence from Developing
Countries. European Journal of Social Sciences. 13(3), 408-414.
Ajaz, T. and Ahmed, E. (2010) The Effect of Corruption and Governance on Tax revenue. The
Pakistan Development Review 49:4 Part II pp.405-417.
Benno, T. (2003) To Evade or Not to Evade: That is the Question. Journal of Socio-economics,
283-302.
Bhartia, H.L.(2009): Public Finance. 14th Edn., Vikas Publishing House PVT Ltd, New Delhi.
Bird, Richard M., Jorge Martinez-Vazquez, and B. Torgler (2008) Tax Effort in Developing
Countries and High Income Countries: The Impact of Corruption, Voice and Accountability.
Economic Analysis & Policy, VOL.38 No.1, March 2008.
Brondolo, J., C. Silvani, E. Borgne, and F. Bosch (2008) Tax Administration Reform and Fiscal
Adjustment: The Case of Indonesia (2001-07) (IMF Working Paper No. 08/129).
Chaudhry, I. S. and Munir, F. (2010) Determinants of Low Tax Revenue in Pakistan. Pakistan
Journal of Social Sciences (PJSS) Vol. 30, No. 2 (December 2010), pp. 439-452
Gupta, A.S. (2007). Determinants of Tax Revenue Efforts in Developing Countries. Working
Paper 184: International Monetary Fund, Washington, DC.
Hausman, Jerry A. 1978. Specification tests in econometrics. Econometrica, 46 (6): 1251-71.
Imam, P. A. and D. F. Jacobs (2007) Effect of Corruption on Tax Revenues in the Middle East.
IMF Institute and Fiscal Affairs Department. (IMF Working Paper No.07/270).
Itriago, Deborah (2011) Owning Development Taxation to fight poverty, Oxfam research report,
September 2011. www.oxfam.org.
Jhingan, M.L(2004): Money, Banking, International Trade and Public Finance. Vrinda
Publications, New Delhi.
Kaufman, D.; Kraay, A. and Mastruzzi, M. (2010) The Worldwide Governance Indicators:
Methodology and Analytical Issues. Global Economy and Development at Brookings, September
2010.
Lutfunnahar, B. (2007). A Panel Study on Tax Effort and Tax Buoyancy with Special Reference
to Bangladesh. Working Paper 715: Policy Analysis Unit (PAU) Research Department
Bangladesh Bank.
Musgrave, R.A. and P.B. Musgrave(2004): Public Finance in Theory and Practice. Tata McGraw
Hill, New Delhi, India.
Ola, C.S. (2001): Income Tax Law and Practice in Nigeria, 5th edition, Ibadan, Dalag Prints and
Park.

	
  

24	
  

Oluba, M.N. (2008) “Justifying Resistance to tax payment in Nigeria”, Economic Reflections
Volume B, No 3, April.
Tax Justice Network(TJN) (2005): Aid, Tax and Finance for Development
Tanzi, V. (1987). Quantitative Characteristics of the Tax System of Developing Countries. The
Theory of Taxation for Developing Countries, New York: Oxford University Press.
Tanzi, V. (1998) Corruption around the World: Causes Consequences, Scope and Cures. IMF
Fiscal Affairs Department, Washington, DC: International Monetary Fund. (Working Paper No.
98/63).
Tanzi, V. and H. Zee (2000) Tax policy for Emerging Markets: Developing Countries.
Washington, DC: International Monetary Fund. (IMF Working Paper WP/00/35.
Teera, Joweria M. (2003) Could Do Better: An Appraisal of Uganda's Tax Performance Relative
to Sub Saharan Africa. University of Bath (Working Paper).
World Bank (2013) World Development Indicators. Washington, DC: World Bank
Wooldridge, Jeffrey M. 2002. Econometric analysis of cross section and panel data. Cambridge
MA: MIT Press.
Worlu, Christian N. and Nkoro, Emeka (2012) Tax Revenue and Economic Development in
Nigeria: A Macroeconometric Approach, Academic Journal of Interdisciplinary Studies Vol 1 No
2, Published by MCSER-CEMAS-Sapienza University of Rome, ISSN 2281-3993, November
2012.

	
  

25	
  

Appendix
Annex Table 1: Summary of Previous Studies on Tax Effort

Studies

Dependent
variable

Lotz and Morss(1967)
developed anddeveloping
countries

Ratio of tax
revenue to
GNP

Shin (1969)
Developed anddeveloping
countries

Tax ratio

Bahl (1971)
Developing
countries

Taxablecapacity

Chelliah, Baas,
and
Kelly (1975)
47 countries
during1969-1971

Tax sharein GNP

Tait, Grätz, andEichengreen(1979)
47 countries
during1972-1976

Tax share in
GNP

Tanzi (1981)
34 sub-SaharanAfricanCountries for
1977
Tanzi (1987)
86 developing
Countries for
1977

	
  

Tax ratio

Tax share in
GDP

SectoralComposition of
Value-Added

Agriculturalshare in GNP(negative, notsignificant)Agriculturalshare (negative,
significant)Mining share(positive,
significant)Agriculturalshare (negative,
significant)Mining share(positive,
significant)Agriculturalshare in
GNP(negative,
not significant)Mining share in
GNP (positive,
significant)Mining share(positive,
significant)Explanatory Variables
Per Capita
Openness of the
Income/Demographic
EconomyCharacteristics
Per capita GNP
Trade Share in GNP (positive,(positive, significant significant forfor the entire sample the entire
and for the low
sample and forincome countries,
the low income
not significant for
countries, notthe high income
significant for
countries)
the high income
countries)
Trade Share in GNP(positive, notsignificant)

Per Capita GNP(positive,
significant)Export share(positive, not always
significant)

Per capita
income(positive, notsignificant)Foreign Debt/
Tax Evasion

Rate of change
in prices(positive,
significant
only for the
low income
countries)

Export share(positive, notsignificant)Non-mineral export
share in GNP(positive,
significant)Non-mineral export
share (positive,
significant)
Per capita
income(positive,
significant)26	
  Tanzi (1992)
83 Countries for
1978-1988

Tax share inGDP

Stotsky and
WoldeMariam(1997) 43 subSaharanAfricanCountries for
1990-1995

Tax share in
GDP

Piancastelli(2001)
developed anddeveloping
countries

Total tax
revenueshare inGDP

Teera (2002)
developed anddeveloping
countries

Tax share
in GDP

Alm andMartinezVazquez(2003);
developed anddeveloping
countries

Ratio of tax
revenue to
GDP

	
  

Agriculturalshare (negative,
significant)Agriculturalshare (negative,
significant)Mining share(negative,
significant)Manufacturing
share
Positive and(negative, notsignificant)Agriculturalshare in GDP(negative,
significant in apanel analysis)
Industry share in
GDP (positive,
significant in atime-series
analysis) Service
share in GDP(positive, notalwayssignificant)Agriculturalshare in GDP(negative andpositive
depending on theestimation,strong negative
impact for low
incomecountries)
Manufacturing
share inGDP(negative,
not significant)Agriculturalshare in GNP(negative, notsignificant)Mining share in
GNP(positive,
significant)

Import share in
GDP (positive,
significant)

Per capita
income(positive, notsignificant forsome years)

Import share inGDP(negative/positive,
not significant)Export share in
GDP (positive,
significant)

Per capita
income(positive,
significant)Trade Share(positive,
significant)

GNP per capita(positive, notalwayssignificant)Foreign debt
share in GDP(positive, notsignificant inallestimations)

Trade share in
GDP (negative andpositive, notsignificant, strong
positive effect forlower middle
income countries)

GDP per capita(negative andpositive, notalwayssignificant)Debt share in
GDP (negativeand positive,
mostlysignificant,Shadow
economy(positive, notalwayssignificant;negative andsignificant inoneestimation)

Trade Share in
GNP, (negative,
not significant)

GNP per capita,(negative,
significant)Shadow
economy share
in GDP,(negative,
significant)27	
  Bahl (2003)
OECD and lessdeveloped
economies

Ratio of tax
revenue toGDP

Non-agriculturalshare in
GDP (positive,
significant)Ahsan and Wu(2005)
Agriculturaldeveloped andTax shareshare in GDP
developing
in GDP(negative,
countries for
significant)19792002
Source: Lutfunnahar Begum, 2007

Trade Share(positive,
significant)Population
growth rate
(positive,
significant)Simplecorrelation
between tax
effort and thesize of shadow
economy(positive, notsignificant)Trade Share in
GDP (positive,
significant)GDP per capita(negative,
significant)Population
growth rate
(negative, notsignificant)Corruption
Level(negative, notsignificant)Annex Table 2: Variable Descriptions and Sources
Variables
Tax effort
Govt. Expenditure
M2 or Broad money
Openness
Urban pop

Institutional Capacity

Control of corruption	  Description
Tax revenue as share of GDP
Annualgovernment
expenditure as share of GDP
Broad money (M2) as share ofGDP
Import plus Export dived by
GDP
Urban population as share of
total population
Averageofgovernment
effectiveness, rule of law,regulatory quality indices andconverted into 0-100 range
Controlofcorruption
perception index, in 0-100
range

Source
WDI
WDI
WDI
WDI
WDI
World Bank, WGI

World Bank, WGI28	
  Annex Table 3: Sample countries
Antigua andBarbudaArmenia
Australia
Bangladesh
Benin
Botswana
Bulgaria
Burkina Faso
Cambodia
Caribbean small
statesColombia
Croatia
Denmark
Dominica
Dominican Republic

Egypt, Arab Rep.

Maldives

El Salvador
Georgia
GrenadaGuatemalaHonduras
Iceland
India
Indonesia

Mali
Nepal
New Zealand
Nicaragua
NorwayPakistan
Paraguay
Peru

Korea, Rep.
LebanonMacao SAR,
China
Macedonia, FYR
Madagascar
Malaysia

Philippines
PolandSt. Lucia
St. Vincent and the
Grenadines
Thailand
Togo
UgandaUkraineUnited Kingdom
Uruguay
ZambiaRomania
Sierra Leone
South Africa
Sri Lanka

Annex 4: Worldwide Government Indicators

The Worldwide Governance Indicators (WGI) is a long-standing research project todevelop cross-country indicators of governance. The WGI consist of six composite
indicators of broad dimensions of governance covering over 200 countries since 1996:
Voice and Accountability, Political Stability and Absence of Violence/Terrorism,
Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption.
These indicators are based on several hundred variables obtained from 31 different data
sources, capturing governance perceptions as reported by survey respondents, nongovernmental organizations, commercial business information providers, and public
sector organizations worldwide. The six indicators are given in following table.
1. Control of Corruption captures perceptions of the extent to which public power is
exercised for private gain, including both petty and grand forms of corruption, as wellas "capture" of the state by elites and private interests. Estimate gives the country's
score on the aggregate indicator, in units of a standard normal distribution, i.e. ranging
from approximately -2.5 to 2.5.
2. Government Effectiveness captures perceptions of the quality of public services, thequality of the civil service and the degree of its independence from political pressures,the quality of policy formulation and implementation, and the credibility of thegovernment's commitment to such policies. Estimate gives the country's score on the

	
  

29	
  

3.

4.

5.

6.

aggregate indicator, in units of a standard normal distribution, i.e. ranging fromapproximately -2.5 to 2.5.
Political Stability and Absence of Violence/Terrorism captures perceptions of thelikelihood that the government will be destabilized or overthrown by unconstitutionalor violent means, including politically motivated violence and terrorism. Estimate gives
the country's score on the aggregate indicator, in units of a standard normal
distribution, i.e. ranging from approximately -2.5 to 2.5.
Rule of Law captures perceptions of the extent to which agents have confidence in andabide by the rules of society, and in particular the quality of contract enforcement,
property rights, the police, and the courts, as well as the likelihood of crime andviolence. Estimate gives the country's score on the aggregate indicator, in units of astandard normal distribution, i.e. ranging from approximately -2.5 to 2.5.
Regulatory Quality captures perceptions of the ability of the government to formulate
and implement sound policies and regulations that permit and promote private sector
development. Estimate gives the country's score on the aggregate indicator, in units of astandard normal distribution, i.e. ranging from approximately -2.5 to 2.5.
Voice and Accountability captures perceptions of the extent to which a country's
citizens are able to participate in selecting their government, as well as freedom of
expression, freedom of association, and a free media. Estimate gives the country's scoreon the aggregate indicator, in units of a standard normal distribution, i.e. ranging fromapproximately -2.5 to 2.5.

Annex 5: Multi-dimensional Poverty Index (MPI)The Multidimensional Poverty Index or MPI is an international poverty measure developedby the Oxford Poverty and Human Development Initiative (OPHI) for the United Nations
Development Programme’s flagship Human Development Report in 2010. The innovativeindex reflects the multiple deprivations that a poor person faces with respect to education,
health and living standards. This brief explains how the MPI is constructed and how it can beused, and summarizes a number of analyses of the MPI figures published in the HDR 2013.

	
  

30