Wednesday April 11 2012

Plug the loopholes if you want to fill the potholes

By Thomas Richardson

A couple of years ago, a pothole on Bukoto Street in Kamwokya, a neighbourhood of Kampala, was so massive and deep that local businessmen jokingly referred to it as Lake Bunyonyi. The real Lake Bunyonyi is breathtakingly beautiful, and is said to be the second deepest lake in Africa. Although it has since been filled, the pothole in Kamwokya was pretty deep as well.

Government cannot fill potholes if it has no money, and that money has to come from taxes. Uganda’s tax-to-GDP ratio is the lowest in the region, which is partly why its potholes are the deepest.

The graph (right) shows that Kenya collects almost twice the level of revenue as Uganda, while Mozambique, Ghana, Tanzania and Rwanda also outperform us. The average for sub-Saharan Africa is almost 27 per cent of GDP, but even if one excludes South Africa and the oil exporting countries, the average is almost 20 per cent of GDP.

To put it in perspective, if Uganda—which now collects around 13 per cent of GDP in revenue—were to collect what neighbouring Kenya does, the extra revenue would cover the full cost of one project the size of the proposed Karuma hydropower dam every year. Collecting more revenue from Ugandan taxpayers—rather than international donors—would also enhance Government’s accountability to its citizens.

Why is revenue in Uganda so low? Part of the answer is the structure of the economies. Kenya’s economy has more manufacturing, which is easier to tax, while several of the others have growing natural resource export bases. But that is only part of the answer.

The Uganda Revenue Authority (URA) seems to be a generally well-run institution, and Uganda’s statutory tax rates are for the most part comparable with those of neighboring countries. So that is not the answer either.

Our view is that the main explanation for Uganda’s poor revenue performance is the country’s widespread system of tax exemptions and investment incentives. What exemptions are there? It would take a lot more space than this paper can afford to list them all, but important ones include almost everything related to agriculture and construction of civic works projects, packaging materials used in the dairy industry, and also computers and software. The automobiles, which caused the pothole in Kamwokya, do not even pay an annual registration fee. In many cases, these exemptions benefit the well-to-do more than the poor or the needy.

There are also a number of incentives provided to investors, and they contribute to Uganda’s poor revenue performance. Studies by the IMF, World Bank, and others around the world offer strong evidence that what investors really want is the following: adequate infrastructure (roads, railway, electricity), a healthy and well-educated workforce, and a fair and efficient judicial system. Government needs tax revenue to provide all of these things.

By contrast, most research on investment incentives shows that they tend to be expensive—in terms of lost revenue—and relatively ineffective in attracting investment. A 2008 IMF study of the Eastern Caribbean calculated the lost revenue at between 9½ and 16 per cent of GDP annually, while the impact on foreign direct investment was marginal at best.

Some in the private sector are now calling for an expansion of Uganda’s system of tax incentives, and even for a reduction in the VAT rate. This would be a mistake: without revenue, Uganda cannot educate its youth, keep its people healthy, build electricity generation capacity, and construct new transport corridors—all needed to attract investors.

By contrast, Uganda stands a chance of having the money to do these important things—and to fill the potholes—if it takes steps in next year’s budget to plug some of the loopholes in the tax system.

Thomas Richardson is the IMF senior resident representative in Uganda.,