# **I. Introduction**

The fundamental objective of taxation is to finance government expenditure. Governments in developing countries sometimes use taxation to fulfill other goals ‐ promote industrial policies, support economic activities deemed to employ the poor and facilitate development of lagging regions. This is achieved through tax incentives – exemptions, tax holidays, deductions and reduced rates for certain categories of taxpayers. While the evidence regarding the efficacy of such policies is mixed (James, 2013), selectivity in applying tax regulations has several negative impacts: 1) it distorts resource allocation decisions as firms make investments based on tax schemes rather than business rational; 2) it creates administrative complexities and increases enforcement and compliance costs and 3) it reduces government revenue.

There is a large literature on challenges and good practices in tax policy design and administration in developing countries (see for example, Heady, 2002, Keen and Simone, 2004 and Bird and Wilkie, 2012). Fiscal experts agree that tax policy should raise revenues without major distortions to the decisions of firms (Easson and Zolt, 2002, Bird and Wilkie, 2012 and OECD, 2010) **.** Taxes are distortive by nature. Corporate income taxes (taxes on profits) reduce returns on capital and discourage investment (Johansson et al 2008). Consumption taxes (sales tax and value added tax (VAT)) reduce spending (Easson and Zolt, 2002). The distortionary effect of taxes increases proportionally to the tax rate (Bird, 2008). Governments can keep the negative effects of corporate and consumption taxes at a minimum by setting the tax rates at the lowest possible level given the revenue needs and by imposing a single rate on a broad base (Bird and Wilkie, 2012; OECD, 2010; World Bank, 2009).

Broadening of tax bases has been a high priority for many developing countries (IMF 2011, Bird, 2008, Heady, 2002). Such reforms help improve the business climate by establishing a level playing field for all firms and by allowing to reduce the overall tax rate. Expansion of tax bases also results in greater public revenue, which gives governments space to invest in a number of public goods (such as electricity, infrastructure or education) and contributes to macroeconomic stability essential for investment attraction. Furthermore, tax legislation with similar rules for all taxpayers reduces compliance costs and supports small business growth and formalization (World Bank, 2009).

For corporate income tax, coverage can be expanded through reduction of tax incentives (see for example Zolt, 2013, Bird and Wilkie, 2012). For indirect taxes, a VAT on goods and services with few exemptions has become popular throughout the world in lieu of its advantages over other types of indirect taxes, such as multistage turnover taxes or single stage taxes at the manufacturing/wholesale/retail level. A detailed discussion of the benefits of the broad based VAT is provided in Lent et al (1973), Ebril et al (2001) and Pomeranz (2012). In short, a broad based VAT eliminates cascading associated with turnover taxes and removes incentives for firms to vertically integrate; it can be waived for exports to support international competitiveness and its self‐enforcing mechanism facilitates higher compliance (Heady, 2002). To ensure neutrality and non‐interference with market processes, VAT has to be applied to all sectors of the economy.

This paper provides an analysis of competitiveness‐related issues surrounding the design and administration of corporate and consumption taxes in four South Asian countries – Bangladesh, India, Pakistan and Sri Lanka. Whenever possible, tax regimes in South Asia are compared with the prevailing international practices. The paper is based largely on the analysis of tax legislation. Additionally, data from 4