Effect of Corruption on Tax Revenues in the Middle East

WP/07/270


Effect of Corruption on Tax Revenues in
the Middle East

Patrick A. Imam and Davina F. Jacobs

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© 2007 International Monetary Fund
WP/07/270




IMF Working Paper



IMF Institute and Fiscal Affairs Department

Effect of Corruption on Tax Revenues in the Middle East

Prepared by Patrick A. Imam and Davina F. Jacobs1

Authorized for distribution by Arend Kouwenaar and Thanos Catsambas

November 2007

Abstract


This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the authors and do not necessarily
represent those of the IMF or IMF policy. Working Papers describe research in progress by the
authors and are published to elicit comments and to further debate.

This study estimates the impact of corruption on the revenue-generating capacity of different
tax categories in the Middle East. We find that the low revenue collection as a share of GDP
there compared to other middle-income regions is due in part to corruption, and certain taxes
are more affected than others. Taxes that require frequent interaction between the tax
authority and individuals, such as taxes on international trade, seem to be more affected by
corruption than most other types of taxation. This suggests that if governments need to raise
more tax revenues in a way that minimizes distortions and maximizes social welfare, they
should implement reforms that either reduce corruption or raise revenues from tax categories
that are less susceptible to corruption. Possible reforms of the revenue system and
administration are examined.
JEL Classification Numbers: H21; H26; H83
Keywords: Corruption; governance; revenue administration, taxation
Authors E-Mail Addresses: pimam@imf.org; djacobs@imf.org


1 Patrick Imam is an economist in the African Department and Davina Jacobs is senior economist in the Fiscal
Affairs Department. The paper was presented at the 63rd Congress of the International Institute of Public
Finance, held August 27–30 at Warwick University. We would like to thank Peter Barrand, Olivier Benon,
Jean-Paul Bodin, Thanos Catsambas, Saade Chami, Edward Gardner, Anne Grant, Zubair Iqbal, Anna Ivanova,
Michael Keen, Michel Lazare, Todd Schneider, and Ling Hui Tan for their valuable comments.

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I. Introduction ........................................................................................................................... 3
II. Corruption in Revenue Administration................................................................................ 5
Factors Related to the Tax System.................................................................................... 7
Factors Related to Tax Administration ............................................................................. 7
Behavioral or Cultural Factors.......................................................................................... 8
III. Comparison of Taxation Systems in Middle East Countries .............................................. 8
IV. Empirical Study ................................................................................................................ 13
A. Hypothesis and Empirical Specifications ...................................................................... 14
B. Econometric Results....................................................................................................... 17
V. Conclusion ......................................................................................................................... 22

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I. INTRODUCTION
The realization that hydrocarbon revenues are exhaustible, uncertain, and volatile has led to a
growing consensus in the Middle East that governments must diversify their tax revenue
sources, which tend to be highly dependent on the hydrocarbon sector. For example,
according to 2006 IMF Article IV reports on Syria and Yemen, at current extraction rates, oil
would run out in a few years, making tax reforms to replace declining oil revenues urgent.
For countries with large oil or gas reserves, such as Saudi Arabia, raising tax revenues is less
urgent, though still necessary for longer-run fiscal sustainability.
Raising taxes in the Middle East is, however, hampered by both a complex tax system and
widespread corruption. Complex and fragmented tax administration has its source in part in
British and French traditions. Contrary to current best practices, in some Middle Eastern
countries, the treasury rather than a separate tax administration collects taxes; in others,
direct taxes and indirect taxes are collected by different agencies (see Crandall and Bodin,
2005). Such dispersed systems of tax administration make it difficult to enforce taxpayer
compliance, though this is not to deny that the Middle East in general, and some countries
like Morocco and Tunisia in particular, have made great strides in improving tax
administration.
The other reason for low tax revenues is widespread institutional corruption; the widely cited
annual Transparency International Corruption Perception Index (TICPI) in 2005 gave the
Middle East as a whole a value of 3.8 and the non-Gulf countries an even lower 2.9 out of a
possible 10.2 True, institutional corruption is not unique to the Middle East. The phenomenon
is widespread in tax and customs administrations in many developing countries, including
most Sub-Saharan African countries and many countries in Latin America and Asia.
However, between 2000 and 2005 the TICPI ranking of the Middle East as a whole actually

2 The Transparency International index is based on the opinion of experts. It intends to capture the extent to
which “high government officials are likely to demand special payments” and “illegal payments are generally
expected throughout lower levels of government” in the form of “bribes connected with import and export
licenses, exchange controls, tax assessments, police protection, or loans.”

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deteriorated, from 4.4 to 3.8.3 Even if we only look at countries for which data are available
for both 2000 and 2005, the indicator worsened slightly, to 4.3 in 2005.
The TICPI statistics might suggest that the Middle East has until now not recognized the
problem that corruption poses for tax and custom administrations. This is misleading.
Countries in the region have implemented or are now implementing institutional reforms that
are critical first steps to reduce corruption. For instance:
• Many countries, such as Egypt, Jordan, and Lebanon have established function-based,
integrated tax administrations, and Francophone countries, such as Algeria and
Morocco, have had a function-based tax administration since the early 1990s.
• Many countries (e.g. Algeria, Egypt, Lebanon, Morocco and Tunisia) have introduced
self-assessment procedures, which are critical to reduce contacts (and opportunities
for negotiation) between taxpayers and tax officers.
• The introduction of information technology may also have been helpful in reducing
face-to-face contacts between tax payers and tax officials. These new technologies
allow for filing and payment systems to take place through banks (e.g. Morocco and
Lebanon) or for large taxpayers directly , while other countries are beginning to
implement such electronic filing and payment systems, initially focusing mainly on
large taxpayers (e.g. Egypt, Tunisia and Morocco).
• Finally, some countries have significantly modernized customs procedures, such as
simplified clearance processes and selective post-clearance audits (e.g. Jordan,
Lebanon and Morocco), again with the intention of reducing opportunities for
corruption.
The issue therefore is not whether tax and customs administration reform is now a reality in
the Middle East but rather whether it has gone far enough in reducing corruption.

3 Comparisons between years should be viewed as indicative; some countries included in 2005 were not
included in 2000.

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Empirical evidence has shown that corruption reduces tax revenues (see Abed and Gupta,
2002, for a summary of explanatory studies). Based on these studies, the public finance
literature has provided general recommendations to raise tax revenues, recommending such
institutional reforms as reinforcing the role of the judiciary to limit corruption. These studies
have, however, looked at the effect of corruption on tax revenues in general, lumping all
taxes together. This ignores the fact that different taxes are likely to be affected differently by
corruption. The aim of this paper is to look at what determines the revenue-generating
capacity of specific taxes to see which are more susceptible to corruption. This would allow
for policy conclusions to be drawn on how to diversify and raise tax revenues more
effectively, which in turn may inform government with policy choices, such as to switch to
taxes that are less susceptible to corruption or to undertake to tackle corruption directly.4
We urge the reader to be cautious about interpreting our findings. The paper deals with the
Middle East as a whole. Its conclusions therefore do not necessarily reflect any particular
national situation—there are a wide variety in the region. In reality, tax and custom
administration reform is now a reality in many Middle Eastern and North African countries.
In what follows, Section II briefly reviews the problems corruption poses for revenue
administration. Section III describes the current revenue structure in the Middle East
generally, and Section IV describes the results of an empirical study to estimate the impact of
corruption on the revenue-generating capacity of different taxes in the region. Section V
outlines possible reforms of the revenue system and administration.

II. CORRUPTION IN REVENUE ADMINISTRATION
For this study, we define institutional corruption as an unlawful or unauthorized act engaged
in by a public official using his or her position to receive a bribe, directly or through a family
member or associate, in exchange for making a benefit available to a member of the public

4 It could still be possible to raise considerable revenue from a tax, even if more could be raised if corruption
were lower. Conversely, a tax such as an excise tax (e.g., on playing cards) may not vulnerable to corruption but
also may never be lucrative. However, such a tax could is highly distortionary and should possibly be shunned.

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(e.g., a taxpayer). Opportunities for corruption in revenue administration are affected by
demand from companies and individuals for corrupt actions and the supply by tax officials of
corrupt acts. Demand for corruption increases with the complexity of tax systems, for
instance, while supply could increase, for example, if the law gives tax officials excessive
discretion.

Corruption is a multidimensional problem. General factors leading to corruption within a
country have to be differentiated from specific factors that affect corruption within the
revenue administration in particular. Factors affecting corruption generally range from the
size of the government in the economy to officials with excessive discretion to inadequate
control systems with limited accountability to cultural norms. Specific factors affecting
corruption in the tax administration are numerous, but tend to have as a common
denominator frequent interactions between the tax administration and individuals. They can
occur in, among other areas, collection, enforcement of arrears collection, appeals, and even
customer service, such as selling taxpayer information and issuing tax identification numbers
and cards to fictitious taxpayers.5

The effect of corruption on tax revenue has to be qualified, however. Corruption sometimes
does not involve taxpayers and may not always affect tax revenue directly. For example,
when tax auditor positions in a revenue administration are “sold” instead of being filled
through proper selection process, the taxpayer is not directly involved. Similarly, if a
taxpayer bribes a revenue administration employee to expedite processing of a tax refund,
this does not necessarily entail a loss of tax revenue (except in present value terms).

To analyze the problem of corruption in revenue administration, the main causes or
motivations need to be explored. Such an examination could yield valuable suggestions for

5 Among the possible forms of corruption in revenue administration, corruption in revenue audit may have the
greatest negative impact on collections (Dos Santos, 1995). Corrupt practices that occur when a taxpayer being
audited could be preceded by tax evasion or understatement of revenue, partly because this is an environment
where negotiating tax liabilities is the norm. A taxpayer not fearing the consequences of being caught will, in
many countries, decide to evade taxes in the belief that even if tax officials detect the evasion, the tax auditor
can be bribed and payment of the proper tax liability avoided.

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preventing corruption. Setting ethical considerations aside, corruption would appear to be
determined primarily by the following causes or motivations (Dos Santos, 1995; Tanzi, 1998;
Keen, 2003):

Factors Related to the Tax System
•
A complex tax system can facilitate corruption. Tax auditors may extort bribes from
taxpayers by taking advantage of complex rules or exercising the excessive discretion
they have because of unclear laws, regulations, and procedures. The taxpayer, who
may well be evading taxes, may choose to bribe the auditor rather than report the
extortion to the revenue administration.
•
High tax rates may lead to more corruption by increasing the incentive for taxpayers
to evade them; however, there is no clear evidence to either validate or refute this.6
•
Lack of sanctions is another important factor stimulating corruption. The likelihood
of corruption increases if penalties are not sufficiently severe (immediate dismissal
and criminal charges) or seldom imposed.
•
When it is time-consuming and costly to appeal, the taxpayer might resort to corrupt
behavior simply to get things done.7
Factors Related to Tax Administration
•
When it is complex and cumbersome to pay taxes, the temptation for corruption as a
short cut could arise, to both save time and reduce uncertainty about how much tax to
pay.

6 Theory does not even provide a clear answer about the relationship between tax rates and the degree of
compliance. If the fine on being caught depends on the amount of income or the amount of tax concealed,
reducing tax rates may lead to an increase or decrease in compliance (see Ivanova, Keen, and Klemm, 2005, for
a literature review).
7 Another possible reason for corruption in the tax administration could be pleasure in “beating the system.”
This motivates some people who believe they are “smarter than the rest” and boast to their friends that they are
bribing the tax auditors. But evidence for this proposition is weak.

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•
When deciding on whether to engage in corruption, individuals take into account their
perceived risk of detection and punishment. If they feel that systems are deficient (the
risk is low), they are more likely to engage in corrupt practices.
•
If wages of revenue administration personnel are very low, corruption may be
considered an acceptable way to supplement income.
Behavioral or Cultural Factors
•
In organizations where corruption is endemic, honest employees may be led into
corruption by the behavior of others. Corrupt employees also exert pressure when
they will not accept that someone in the group should behave properly while others
are engaging in corrupt practices. If senior revenue administration officials are known
to engage in corrupt practices, lower-level employees have another justification to
engage in similar practices.
Evidence from around the world has made it clear that corruption in revenue administration
is a serious problem. In some countries, like Peru and Uganda, corruption in the tax
administration was so endemic that the government closed it down and started a new one. In
many developing countries applications for poorly paid customs jobs are far higher than for
similarly paid government jobs, which suggests applicants saw as possibility of making extra
money (Abed and Gupta, 2002). Anecdotal evidence has shown that where revenue
administration processes have been modernized, as through the creation of a fully functional
Large Taxpayer Office (LTO) and the computerization of customs procedures, revenue
collections have improved and corruption has been reduced (Dos Santos, 1995).

III. COMPARISON OF TAXATION SYSTEMS IN MIDDLE EAST COUNTRIES
To establish whether specific types of tax are indeed prone to corruption, it is useful to first
analyze how governments in the Middle East finance themselves. In this study, the Middle
East is defined as Algeria, Bahrain, Comoros, Djibouti, Jordan, Kuwait, Lebanon, Libya,
Mauritania, Morocco, Oman, Qatar, Saudi Arabia, Sudan, Syria, Tunisia, and the United
Arab Emirates; Iraq, Palestine, and Somalia are excluded for lack of data.

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