# **Revenue Potential, Tax Space, and Tax Gap: A Comparative Analysis**

## **_1. Introduction_**

The decade 2000-2010 has witnessed major changes in tax systems globally. The aim of meeting the Millennium Development Goals has put greater realization in developing countries to improve their domestic resource mobilization in a concerted manner. Although the study looks at tax space and tax gap in 61 countries, the main focus of the study is post-socialist countries of Eastern Europe, Russia and Central Asia During the last two decades the countries of Eastern Europe and Central Asia (ECA) have experienced significant changes in their political and economic systems while moving towards more democratic institutions and free market systems. Simultaneously, issues regarding fiscal sustainability have become important due to the size and composition of public expenditure and the speed and scope of tax reforms.

The high and growing levels of public spending have imposed high tax burdens on the economy. The early transition years involved “multiple shocks”<sup>1</sup> with the removal of employment guarantees in state-owned enterprise, a rise in open and hidden unemployment and a rise in cash transfers and social security payments. In addition, public spending on other categories as well like wages and salaries, capital expenditures, and on public health and education has also continued to rise.

The legacy of planned socialism has also had an impact on the present tax systems. Primary among these are a lack of a tradition of voluntary compliance, ‘negotiated taxes’ for firms, a weak and underdeveloped tax administration, and public distrust of government institutions (Martinez-Vazquez and McNab, 2000). All these factors along with a tradition of corrupt government practices and a large and growing “shadow” economy which escapes the tax net have contributed to lower levels of tax compliance and tax evasion.

The countries chosen for this study have embarked on their growth paths with uneven economic growth and uneven tax effort among these countries. ‘Tax effort’ is defined as the ratio between the actual revenue collected and the revenue potential of an economy. Low tax effort hinders sound fiscal policy. However, tax revenues can be increased through a better mix of tax reform policies and strengthening of the tax administration. The question is: should revenues be increased beyond the economic capacity of a country. This regional study ranks countries by their tax collection efforts and tax potential, and tries to understand whether taxing beyond what the economic potential would allow it to results in lower tax productivity and lower tax effort.

## **_2. Definitions: Tax effort, revenue potential, tax space, and tax gap_**

The absolute tax effort, or the ratio of actual tax collected to GDP, is a good indicator of the tax collection trends of a single country over a period of time. However, this ratio does not capture the tax potential or tax capacity of a country, or whether a country is putting in enough effort to mobilize its resources in comparison with other countries. To facilitate more effective cross-country comparisons, several studies have used a regression approach to estimate the tax potential. Using this approach, the “revenue potential”, or “tax capacity” for a country is first estimated as its predicted value from a regression that controls for the individual characteristics of a country. Based on this, an index of the “relative tax effort”, or the actual tax collected to the potential tax (both as a share of GDP), is computed to facilitate easier cross country comparisons.

> 1 World Bank. 2007. p25

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