Aligning Incentives: The Effectiveness of Performance-Based Pay for Tax Officials

In developing countries, tax revenue collection rates continue to lag behind those in developed countries for several socioeconomic and political reasons. A key challenge for governments in developing countries is creating compensation structures for tax officials that incentivize collection without creating opportunities for over-taxation or bribery from taxpayers.

In “Tax Farming Redux: Experimental Evidence on Performance Pay for Tax Collectors” Adnan Khan, Asim Khwaja, and Benjamin Olken evaluate the impact of compensation structures for tax officials in Punjab, Pakistan, that are based on revenue collected from property taxes. The authors find that, on average, performance-based pay yielded a substantial 46 percent increase in the growth rate of tax revenues, primarily driven by the reassessment of a small number of high-value commercial properties.

Historically, governments have addressed tax collector corruption by employing “tax farmers,” who are paid a fraction of the revenue they collect. However, the level of empowerment and authority that was given to these tax officials frequently led to taxpayer dissatisfaction and over-taxation. Thus, over the past several hundred years, aided by third party verification systems and financial and administrative data, developed countries switched to systems with salaried tax officials. These collection regimes may still be inadequate in driving greater efficiency for tax collectors in developing countries, where governments lack strong financial or technological resources. Khan et al. explore the potential for performance-based pay structures to reduce corruption and increase efficiency for tax bureaucracies in developing nations.

Punjab, the most populous province in Pakistan with a population of over 80 million, has a property tax collection level that is roughly one-fifth the level of a country of similar size because the current system offers substantial opportunities for bribery and corruption. Tax officials are pressured to meet explicit financial targets but are paid low wages and face inconsequential threats for underperformance.

Tax officials also maintain almost complete control of the property database, for which submissions are handwritten, allowing them to manipulate records easily. Misclassifying a property in the database also can have a significant effect on revenue levels—for example, a commercial property is taxed three to six times higher than a residential property and rented property is taxed ten times higher than an owned property.

Khan et al. randomly assign three types of performance-based incentives to Punjabi tax officials that have varying degrees of subjectivity: 1) “Revenue,” in which tax officials were paid their current salary plus a bonus based on the level of revenue collected above a particular benchmark; 2) “Revenue Plus,” which is the “Revenue” structure with an additional measure based on taxpayer satisfaction and a bonus increase for high performers or a bonus reduction for low performers in this measure; 3) “Flexible Bonus,” in which officials were again paid their current salary, but high and low performers were rewarded or punished based on performance rankings that were determined by a “Performance Evaluation Committee,” comprised of senior tax officials.

The authors find that all three incentive structures increased tax revenue, but that the “Revenue” scheme had the greatest impact. Under that scheme, revenues increased approximately 57 percent in the first year. The “Revenue Plus” scheme had slightly lower revenue levels, but taxpayers reported higher levels of satisfaction with the tax authorities and greater accuracy of property assessment. The “Flexible Bonus” scheme performed the worst on all measures, likely a result of the subjectivity and potential politics underlying committee rankings. This highlights the benefits of using a mainly objective measure of performance, such as level of revenue collected.

Interestingly, the increase in revenue levels was primarily from reassessment of a small number of properties that were reclassified as commercial or rental property and thus taxed at a higher rate. Additionally, despite the revenue merits of performance-based pay, bribe payments increased by an unsettling 30 percent and were paid more frequently.

While performance pay may help address some major revenue collection issues, it cannot necessarily eliminate or even reduce the corruption and collusion between tax authorities and taxpayers. However, the results of this field experiment provide a promising avenue for a long-term solution to the widespread taxation issues in developing countries.

Article Source: “Tax Farming Redux: Experimental Evidence on Performance Pay for Tax Collectors,” Adnan Q. Khan, Asim I. Khwaja & Benjamin A. Olken, National Bureau of Economic Research, Working Paper, October 2014.

Feature Photo: cc/(Abhijit Tembhekar)