Why Developing Economies Must Focus on Tax Base, Not Just Raising Rates

In a groundbreaking study from the Asian Development Bank (ADB), authors Jong Woo Kang and Lovely Tolin, working under ADB’s Economic Research and Development Impact Department, examine how developing economies can more effectively raise tax revenues. Drawing on insights from globally respected institutions including the International Monetary Fund (IMF), the World Bank, and the Organisation for Economic Co-operation and Development (OECD), the paper argues that raising tax rates alone is insufficient. Instead, it is the breadth of the tax base, the portion of economic activity subject to taxation, that determines whether tax policy reforms succeed in generating revenue. Their study, Effective Mechanisms for Raising Tax Revenues, builds both theoretical models and empirical evidence to show how countries can close the persistent tax-to-GDP gap with advanced economies.

Raising Rates Isn’t Enough

The study begins by addressing a critical challenge for many developing countries: how to raise more tax revenue without stifling growth or deepening inequality. Although higher tax rates might seem like a direct route to higher revenue, the reality is far more complex. As the researchers show, relying solely on rate hikes often leads to diminishing returns. This is because higher rates can trigger tax avoidance, encourage informality, or reduce economic activity, particularly when administrative capacities are weak. The classic Laffer Curve concept is invoked to explain this dynamic: after a certain point, increasing the tax rate results in less, not more, tax revenue. Therefore, unless higher tax rates are matched with broader tax bases and better enforcement, their effect can be neutralized or even reversed.

Theoretical Model Reveals Tax Base is Key

To better understand the interplay between tax rates and revenue, the authors construct a two-economy model. Country A represents a developing economy with a low tax-to-GDP ratio, while Country B stands for an advanced economy with a higher one. The model breaks down the gap in tax performance into two variables: the tax rate and the tax base ratio. Their key finding is that increasing the tax base, the share of GDP that is effectively taxed, has a far more reliable and sustained impact on revenue than merely increasing the rate. Moreover, the model reveals that the benefits of tax rate hikes diminish unless the tax base is growing. In fact, the model includes second-order effects, showing that once the base is expanded beyond a certain level, further rate increases have less impact. Conversely, in systems with narrow tax bases, even small increases in rates can backfire.

Evidence from Around the World

To validate their theory, the researchers use data from 154 countries between 2004 and 2022. Tax data were pulled from sources like the IMF Government Finance Statistics, the World Bank’s World Development Indicators, Trading Economics, and recent academic work by Bachas et al. The authors used a robust econometric approach, the Instrumental Variables Two-Stage Least Squares (IV-2SLS), to control for reverse causality and endogeneity between tax rates, tax base, and revenue. The analysis confirms that the combination of a higher tax rate and a broader tax base results in significantly higher tax revenue. But crucially, when the tax base remains narrow, increasing tax rates does not meaningfully improve revenue outcomes. Interaction terms in the regression models were especially telling, showing that a broader base magnifies the positive effect of rate hikes, while narrow bases undercut it.

Different Impacts by Income Level and Region

The effectiveness of tax reforms varies widely by a country’s income level and region. In low-income countries, tax rate increases show weak or even negative revenue impacts unless the tax base is also expanded. At a tax base ratio of 1, the marginal effect of a tax rate increase becomes strongly positive (up to 0.746). For lower-middle-income countries, the gains are even greater, suggesting that countries in this bracket are particularly well-positioned to benefit from coordinated reforms. High-income countries, by contrast, already have broad tax bases and enjoy the most reliable revenue gains from rate adjustments.

Regionally, the European Union and Latin America show the strongest effects, particularly at higher base ratios. Africa, Asia, and ASEAN countries see more modest, but still positive, returns. The Middle East, however, stands out as an exception, likely due to its heavy reliance on non-tax revenues such as oil. These findings reinforce the idea that tax policy cannot be one-size-fits-all. Countries must tailor their strategies based on their economic structure, administrative capacity, and existing tax base breadth.

Policy Lessons: Broaden the Base Before Raising Rates

The overarching message of the study is clear: governments must focus on expanding the tax base before turning to rate hikes. That means tightening tax administration, reducing exemptions, closing loopholes, and encouraging the formalization of economic activities. In countries with weak institutions, simply raising rates could deepen inefficiencies and even reduce tax compliance. Conversely, expanding the base not only boosts revenues but also spreads the tax burden more evenly and equitably across society. The authors stress that a broad-based, low-rate approach, echoing OECD recommendations, can deliver both economic efficiency and social fairness.

The ADB’s research provides critical guidance for developing economies under pressure to mobilize domestic resources. It offers both empirical and policy validation for a shift in strategy: one that goes beyond reactive tax hikes and toward foundational reforms that expand the taxable economy itself. As fiscal demands rise to meet the Sustainable Development Goals, climate adaptation needs, and post-pandemic recovery, getting tax policy right is more urgent than ever. This study offers a roadmap to do just that.