Information technology and fiscal capacity in a developing country: evidence from Ethiopia Presented at the ICTD Annual Centre Meeting 2014

1. Information technology and fiscal
capacity in a developing country:
evidence from Ethiopia
Merima Ali
CHR Michelsen Institute
Abdulaziz B. Shifa
Maxwell School, Syracuse University
Abebe Shimeles
African Development Bank
Firew Woldeyes
Ethiopian Development Research Institute

2. Introduction
• A limited fiscal capacity of the state has
received increased attention as an important
constraint to economic development.
• In the year 2006, the average GDP share of
government revenue in low income countries
was 12.1%. For high income OECD countries,
it was 25.2%

3. Introduction(contd.)
• Building fiscal capacity is not a costless
endeavor.
• Tax enforcement requires gathering detailed
earning information on large number of tax
payers.
• The advance in information technology (IT)
offers a cheaper possibility to gather and
analyze large amount of data on tax payers.

4. Introduction (contd.)
• Over the past decades, “reform efforts in tax
administration in developing countries have
generally centered on IT”,Bird and Zolt (2008).
• Nevertheless, there has been little, if any,
systematic empirical evidence on the impact
of those reforms.

5. Objective of the study
• Provide evidence on the impact of using
electronic sales registry machine (ESRM) on tax
compliance.
• We look at the impact of ESRM on the amount
of the value added tax (VAT) paid by firms.
• We use administrative firm level panel data on
large number of business tax payers in Ethiopia.

6. Electronic Sales Registry Machine (ESRM)
• Starting in 2008, the Ethiopian Revenue and
Customs Authority (ERCA) required several
businesses to use ESRM.

7. Electronic Sales Registry Machine (contd.)
• The machines register sales and issue receipts
(print out of an electronic receipt).
• ESRMs are connected, through a general
packet radio service, to the central data base
of ERCA providing real-time data on each
transaction.
• This has enabled ERCA to monitor reported
revenues of firms on a day-to-day basis.

8. Electronic Sales Registry Machine (contd.)
• Harsh legal punishments have been enacted
to discourage failure to issue the electronic
receipts.
• ERCA initially targeted relatively large tax
payers for ESRM use and gradually expanded
the implementation to smaller firms.

9. Number of VAT payers and ESRM users (`000)
thousands

10. Background to taxation in Ethiopia
Government revenue and expenditure as percentage of GDP
(2001-2011)

11. Government tax revenue by source (percent of total tax revenue)
Background to taxation in Ethiopia (contd.)

12. Background to taxation in Ethiopia (contd.)
• Several reforms to improve the tax system
have been implemented that can be
categorized into two broad aspects:
(1) introducing new taxes to broaden the
domestic tax base: (the introduction of VAT in
2003).
(2) improving the administrative capacity of the
tax authority (greater use of IT in tax
administration).

13. Introduction of VAT
• Introduced in 2003, the VAT is the single
largest component of domestic indirect tax.
• Over the past five years, VAT contributed
nearly half of the indirect domestic tax and 20
percent of the total domestic tax.

14. VAT as percentage of total domestic tax revenue

15. Number of VAT payers and ESRM users (`000)
thousands

16. Data
• Our dataset contains the entire set of firms in
ERCA’s database.
• Monthly unbalanced panel observations on
nearly all of the tax payers – consisting of about
85 thousands firms.
• The data has information on amount of VAT and
ESRM use (the date)
• The data covers the period from January 2003 –
when the VAT was introduced in Ethiopia – to
July 2014.

17. Empricial Results
• Our econometric approach involves comparison
of taxes before and after the ESRM use.
• We limit our analysis to those tax payers that
have paid VAT both before and after using
ESRM.
• We also exclude few firms that are owned by
the government.
• This leaves us with 33,158 firms and 738,604
observations for the econometric analysis.

18. Comparison of VAT per firm between ESRM users
versus non-users (in 2003 prices, ‘000 Birr).

19. Simple mean comparision
Average monthly VAT = 57,866 Birr
Pre-ESRM use = 50,700 Birr
Post-ESRM use = 63,300 Birr
• the simple mean comparison doesn’t take care of
several relevant concerns.
- overall policy changes may confound with
introduction of the ESRM use.
- part of the change is likely to come from time
trend from confounding facts (such as inflation and
firm growth).

20. Regression specification
log Taxj,t = ∑ βzIj,t,z + µ j + ψt + ε j,t
z∈Z
• Taxj,t is the tax paid by firm j in time t
• z ∈ Z = {z, z + 1, . . . , −2, −1, 1, 2, . . . , z¯ − 1, z¯}
denotes the number of periods (quarters) around the
beginning of ESRM use. For periods preceding/following
ESRM use
• Ij,t,z is an indicator variable that equals one if the number
of periods around ESRM use for firm j in time t equals z;
otherwise, I j,t,z equals zero.
• µ j and ψt are firm and time fixed effects; ε j,t is the error
term.

21. Impact of ESRM on log VAT
(estimated βz’s and 95% CI)

22. Heterogeneous effects
• Looking at the impact of ESRM use between
firms that are likely to have different costs of
evasion.
• Hypothesis: those firms that have a higher
cost of evasion, and had not been evading,
even prior to ESRM use should not be affected
by its introduction.

23. Heterogeneous effects
Potential differences in the likelihood of evasion
across different ownership structure of firms;
(i) Personally owned firms: usually family run
businesses
(ii) Institutionally owned firms: such as
shareholders and cooperatives

24. Heterogeneous effects (contd.)
• Institutionally owned firm are typically large in size
and owned by larger number of owners (shareholders)
• The managers of share companies are not necessarily
the owners.
• An agency relationship that necessitates the need for
availability of verifiable information to shareholders
about the performance of the managers.
• Their relatively larger size makes them a valuable
revenue source for the government.

25. Heterogeneous effects (contd.)
• In institutionally owned firm’s, its
creditworthiness in contractual obligations is
likely to depend on its ability to present a
legally verifiable record on its financial state.
• The same records of firm’s, creditworthiness
can be used by the tax authority to trace the
firm’s revenue

26. Heterogeneous effects (contd.)

27. Robustness checks
• Robustness checks done that pertain to the following
major concerns with the forgone regressions.
1. The above specification may not completely address
biases that arise from time varying factors that also
increase a firm’s revenue/sale
• However, this may not be a concern due to two reasons
 The selection criteria used by ERCA are focused on firm
characteristics that are unlikely to fluctuate over time.
 Analysis of trends prior to the ESRM use suggest that
changes in tax payments after ESRM use are not associated
with differences that existed among firms prior to ESRM
use.

28. Trends prior to ESRM use:
mean log VAT and 95% confidence interval

29. Robustness checks (contd.)
2. Differential time trend
a) across different regions
(if the ESRM use is expanded across regions in a
non-random pattern, the differential time trend
across regions may bias our estimated effect)
-We run the regressions allowing for district-specific
time effects (for 81 districts).
-The R-Square increases substantially but the results
remain the same

30. Robustness checks (contd.)
b) Across sectors (rather than regions)
- There are 193 types of sectors in the data
- The results remain the same after controlling
for sector specific fixed effects
3. Change in the composition of our sample
- not all of the firms in our sample are
observed during the entire period

31. Robustness checks (contd.)
• Part of the observed dynamics in the periods
around the beginning of ESRM use could be a
result of this change in composition of firms,
rather than the actual effect of ESRM use.
• We run the regression including only the firms
that are observed for at least a year and two
years before and after the ESRM use.
• The results remain the same

32. Conclusion
• We document the first empirical evidences on the
impact of ESRM on tax compliance using micro
data from Ethiopia.
- tax payments by firms increase in the aftermath
of the ESRM use.
- the effect is driven primarily by personally owned
firms, which we believe are more likely to evade
taxes.
This result suggests that the ESRM use minimized
evasion among firms that are more likely to evade
taxes.

33. Conclusion (contd.)
• The evidences point to a possible positive
contribution of the IT revolution to fiscal
capacity in developing countries.
• However, this conclusion comes with an
important qualification.
• We estimated the effect on firms that are
already registered as tax payers – a relatively
small fraction of the firms in the country.

34. Conclusion (contd.)
• If the increased enforcement via ESRM use
forces firm to operate underground, the
revenue gains from ESRM use may be
weakened due to increased informality.
• The extent to which increased enforcement
through ESRM use leads to a higher level of
informality should be an interesting agenda
for future research.