Good news, you don’t have to pay tax – you’re an international development consultant
This is how I was greeted when I went to sign my first contract in international development at the finance ministry of a developing country. It was my first peek into the world of tax exemptions for foreign assistance on my first foray into a developing country. And it was entirely inconsistent with what I was there to do – help the country to collect more tax revenue to fund development.
Many international experts are exempt from taxation in the countries they advise under agreements between donors and recipients. They work side-by-side with civil servants, use the same roads, benefit from the same police and justice system, but pay no local taxes.
The invisible world of tax exemptions for foreign assistance
Similarly, as you travel the paved road between Roberts International Airport and Monrovia, Liberia’s capital city, you see signs declaring that the road and its upkeep are paid for by the European Union and United Kingdom. You’ll likely pass many vehicles with aid agency and NGO logos on the side, travelling back and forth between the many buildings they occupy.
But you won’t see the exemptions from taxation that underpin international development: the foreign contractor paid no tax in Liberia on its profits from paving the road; the aid agency paid no import duties and sales taxes on its vehicles; and the international expert paid no income tax in Liberia and perhaps anywhere in the world. You won’t see the often-secret agreements of dubious legal standing that exempt foreign assistance from tax. And you won’t see how much tax revenue is being lost from those agreements.
As donors step up their efforts to support domestic resource mobilisation (DRM, development-speak for raising taxes and other finance for infrastructure and public services) the practice of tax exemptions for official development assistance (ODA) is coming under greater scrutiny. Why do donors insist on exemptions from taxation in the very same countries they are supporting to increase tax revenues? And is this practice good, bad or inconsequential for development outcomes?
These questions were discussed in our latest research and at a recent UN Economic and Social Council (ECOSOC) special meeting.
The arguments for ODA tax exemptions
Germany’s representative made four arguments, made often by donors, for exempting ODA from taxation. First, it avoids high compliance costs for donors from operating in multiple different tax jurisdictions, especially as some tax administrations don’t work as they should in developing countries. Second, it protects political buy-in for ODA, which is higher for targeted projects than untargeted budget support (i.e. giving money directly to the government to allocate through its national budget), especially in countries where institutions are weak, corruption is high, and funds can be used in ways not consistent with donor values. Third, taxes reduce the funds available for development projects. Finally, there are costs to renegotiating bilateral treaties and other agreements across many countries, especially as these contain more than just tax exemptions.
Issues with ODA tax exemptions
The IMF raised three broader issues. First, ODA tax exemptions are inconsistent with efforts to support DRM, standard donor advice on tax exemptions and tax certainty, and the international tax system where advances are being made elsewhere toward consistency of approach. Second, ODA tax exemptions lack transparency. Sometimes they are provided in international treaties, but often they are provided in unpublished agreements or letters with dubious legal status. In some cases, not even the tax administration knows the legal basis. Third, they create governance issues, as these agreements are often negotiated and managed by agencies other than finance ministries, undermining fiscal control.
The impact on developing countries
Djibouti and Liberia highlighted a common set of problems among low-income countries, which are in line with the findings of our survey of ODA-recipient countries. Both countries have large donor-funded sectors (worth 92% of the national budget in Djibouti and 143% in Liberia) and the revenue foregone (the tax lost due to the exemptions) can be large – Djibouti estimates them to be 13–15% of total revenues. Broad-based exemptions (effectively exempting from taxation everything a donor does, or funds others to do) undermine the tax system, lead to revenue leakages, distort the economy and set a bad example. Tax exemptions for ODA are expensive to administer – Djibouti has 20 agents working full time on these cases, not surprising given it is being asked to administer one general tax regime and thirty donor-specific regimes.
So, should donors pay taxes in the countries they support?
If tax exemptions for ODA do enable donors to provide more foreign assistance, are the negative impacts on developing country tax systems a price worth paying? Despite 70 years of tax-free ODA, there’s relatively little empirical evidence to answer this question. That’s why further research is so important, as well as assessing the impact of recent decisions not to seek ODA exemptions made by some donors, such as Denmark, Netherlands and Norway.
Donors don’t necessarily have to pay tax to reduce some of the negative impacts from claiming tax exemptions. They could stop negotiating secret agreements for tax exemptions and instead work within the recipient country’s tax system and international tax norms. In many cases, the exemptions donors request would already be available under domestic tax law or international tax treaties. They should make use of these first, before requesting special treatment.
Where they do request exemptions, they should work with recipient countries to assess the impact of those exemptions on the development programme and recipient-country tax system. Donors could also register with local tax authorities and withhold tax on payments to service providers that are not tax-exempt, and end the ‘don’t ask, don’t tell’ practice of contracting that enables contractors to avoid paying income tax anywhere in the world.
So, should donors pay taxes in the countries they support? I did. And even though there was no DTA between my home country and the country I worked in, I received a credit for foreign taxes paid – leaving me no better or worse off. In many cases I believe ODA providers could pay taxes in developing countries and be no better or worse off, but the countries they support would benefit enormously.