Complex tax regulations with different rules for different types of taxpayers increase opportunities for fraud and corruption and are more costly to administer and comply with. Tax incentive schemes with a large number of beneficiaries are difficult to enforce. Tax administrations require more sophisticated data systems and more frequent and detailed audits to prevent fraud in countries that offer a lot of exemptions from general tax rules. Even with these efforts, a significant amount of revenue is lost annually to illegal activity from businesses that do not qualify for tax concessions but falsify documentation to look like they do.

Tax policies in South Asia resulted in narrow tax bases and low government revenues. Indeed, even though corporate tax rates are above global average and VAT rates are comparable to global average, tax revenue is lower than in countries at similar levels of development. Low tax revenues result in inability of governments to fund public goods (such as infrastructure, education systems or courts) that are important for attracting investment in all sectors. They also contribute to fiscal imbalances and macroeconomic instability that have a negative impact on investment climate and economic growth more broadly.

# **The Way Forward**

The reform of tax legislation in South Asia should be guided by several important principles. Tax legislation should have minimum influence on what to produce or consume, where to locate a production facility and how to produce goods. It should also offer stability and any changes should be preceded by sound economic analysis on the costs and benefits for the economy and impact on taxpayers. There is broad consensus that a reasonable tax rate with minimal exemptions broadens the base, levels the playing field for all types of investments and increases revenue collection.<sup>64</sup> For example, Egypt removed most tax exemptions and reduced corporate income tax from 40 to 20 percent in 2004. The number of tax returns filed in just one year jumped by 50 percent and the tax revenue increased from 7 to 9 percent of GDP even though tax rates were halved.<sup>65</sup> Governments in South Asia should consider eliminating most special corporate tax schemes. This can be done by grandfathering existing privileges, i.e. firms that are currently eligible for tax holidays will continue enjoying them until expiration but no new tax concessions for specific industries or firms will be allowed. Keeping or granting of tax concessions should be based on clear criteria available to the public. For example, investments of public good character – e.g. in R&D, infrastructure, environmentally friendly technologies, can receive special tax treatment because of social benefits and positive externalities that they yield. Such practices are common in OECD countries.

Any public support to small firms should aim at encouraging their growth. Current policies in South Asia are incentivizing the opposite outcome. Small firms are eligible for reduced rates, presumptive taxation and exemptions (in the case of Bangladesh). This creates an incentive for firms to stay small or underreport their profits. A better way to support small firms is to make compliance with tax regulations (for both income tax and VAT) easier by simplifying reporting requirements and reducing the number of payments **.**

> 64 See, for example, Bird, Richard and Scott Wilkie. 2012. Designing Tax Policy: Constraints and Objectives in Open Economy, International Center for Public Policy, Georgia State University

> 65 World Bank. 2009. A Handbook for Tax Simplification, Washington DC

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