Rethinking Personal Income Taxation in Asia and the Pacific: Future Directions

Personal income taxes remain weak in the developing countries of the region. Several factors have contributed to this weakness, including a rapidly changing economic environment. Traditional approaches to taxation, focused mainly on corporate tax incentives to attract foreign direct investment and layers of sometimes overlapping and poorly structured sales and international trade taxes, have failed to capture growing sources of personal income or address the gaps in the distribution of income and wealth.

The weaknesses in tax policy are compounded by shortcomings in tax and customs administration. Labor forces characterized by widespread informality, a lack of a culture of tax compliance, and weak governance structures undermine the collection of revenues, especially of the personal income tax. Even when they can identify required reforms, tax and customs administrations often lack the political independence to implement them.

Reform of the region's personal income taxes presents an opportunity to bolster revenues and help address income and wealth inequality. A well-structured personal income tax system with broad bases and moderate and internationally competitive rates can facilitate higher growth and much-needed revenue to fund government spending. A progressive personal income tax (i.e., where the average tax rate rises with higher income) can contribute to the reduction of income and wealth inequality, especially when supported by adequate spending on human capacity development.

The region has made significant, though widely varying efforts, to improve tax and customs administrations in recent years, including through institutional reorganization of tax administrations on a functional basis, better coordination between tax and customs administrations, and the creation of large taxpayer units. Countries in the region have focused on automating their systems, strengthening training and staff quality, and improving legal systems that underpin tax enforcement.

In the region, improvements in the structure and administration of the personal income tax have facilitated sensible reforms of corporate income and broad-based sales taxes while allowing continued reduction of reliance on international trade taxes. In recent decades in the Asia and Pacific region, there has been some increase in reliance on personal income taxes, but the growth has been uneven and insufficient (Figure 1). In the region as a whole but excluding certain key countries, fiscal policies have contributed to some narrowing of income and wealth gaps (Figure 2).

Figure 1: Tax Revenue by Source Comparison 2017-2021 to 2002-2006

Notes: Appendix 1 in the original paper provides the economies by region. Data for the People’s Republic of China and India are missing. Data for East Asia include only Mongolia in 2006; thus, the comparison is limited. Table A1.2 in the original paper lists the economies by region. The percentage change in tax revenue by source compares each tax type’s average share of total tax revenue over two periods: 2002–2006 and 2017–2022.
Source: OECD. Global Revenue Statistics Database (accessed 31 August 2024).

Figure 2: Change in Market Gini Coefficients over Time in the Asia and Pacific Subregions

Source: Standardized World Income Inequality Database Version 9.7 (accessed December 2023).

• High thresholds: Many countries set income thresholds for personal income taxation that are excessively high in growing economies, allowing a significant portion of income to escape the tax net.
• Inefficient tax preferences: Extensive tax preferences, including exemptions and deductions, erode the tax base and disproportionately benefit higher-income individuals.
• Insufficient capital income taxation: This income, derived from interest, dividends, and capital gains, is a key component of the personal income tax but plays an undersized role in the developing countries of the region. And when taxed, it is often taxed at too low a rate to contribute much to revenues.

• Weak compliance: The prevalence of informal employment, political interference in taxation, and often ineffective tax and customs administrations leads to significant compliance gaps, which need to be addressed through comprehensive revenue administration reform.
• Underdeveloped withholding systems: Withholding systems on labor income and some forms of capital income, and the use of third-party reporting are insufficiently developed to achieve their full potential to raise compliance.
• Limited benefits of automation: Automation has yet to yield its full benefits, such as allowing a reallocation of staff from low productivity activities to higher productivity ones, guiding auditing and enforcement, and enabling better coordination of tax and customs administrations.
• Constraints on staffing: Civil service constraints and political interference prevent tax and customs administrations from having the well-qualified staff needed to administer taxation in a complex modern economy.

In most developing countries, there is a concentration of personal income tax liabilities and payments from relatively few higher-income taxpayers. These taxpayers also receive a disproportionate share of hard-to-tax income. There remains considerable scope to use specialized techniques to improve compliance among this group of taxpayers. The region also needs to engage fully with global initiatives in information sharing and enforcement.

• Set an appropriate personal income tax threshold, based on a measure of subsistence income and with administrative considerations in mind, below which the taxpayer pays no tax on income.
• Use a progressive marginal tax rate schedule, with brackets set mainly on revenue considerations.
• Ensure that the total income tax wedge is not excessive and international mobility of high-income taxpayers is kept in mind.
• Limit inefficient exemptions, deductions, and credits. The goal is to aim for the broadest possible base while still allowing some tax preferences that account for taxpayers’ ability to pay, such as high medical expenses.
• Increase the uniformity of capital income taxation and try to keep an equivalence to labor income taxation to avoid distorting markets. Provide some exemption or reduction of the top rate on long-term capital gains.
• Develop effective tax policy units, which work with revenue administrations to collect and analyze data and economic developments and can forecast revenue accurately.
• Enhance tax administration structures by adopting a functional organization to the tax administration, developing effective coordination between tax and customs administrations and other organs of government, improving compliance risk management, making full use of the benefits of automation, staffing tax administrations with adequate, properly trained staff, and implementing a meaningful interest and penalty regime for tax evaders.
• Strengthen tax withholding on wages and salaries and on certain forms of capital income and third-party reporting including from financial institutions.
• Make use of specialized approaches to high net income and wealth taxpayers following models found in OECD countries and nascent approaches in the region.

J. Stotsky and M.H.C. Jaber. Personal Income Taxation in Asia and the Pacific: Future Directions. The Governance Brief. No. 59. Asian Development Bank.