The Taxman's Dilemma: Why making the rich (not the ultra rich) pay more could make everyone poorer

Bangladesh's National Board of Revenue officials are grappling with a familiar challenge. Under pressure from the IMF to boost tax collection by 0.6% of GDP—part of a $4.7 billion loan package—they face a choice that has bedevilled developing economies for decades: whether to extract more from existing taxpayers or cast the net wider to catch new ones.

The easy answer—squeezing those already in the system—is proving irresistible. This month, Bangladesh announced plans to raise VAT rates from 4% to 15% for businesses with annual sales exceeding 5m taka ($45,000). The government is also removing exemptions on everything from home appliances to limestone. It is a textbook case of what economists call "deepening" the tax base. It is also, I think, is a dangerous mistake. This is due to a favourite economic phenomenon of mine called 'The collective action problem'.

In the bustling markets of Dhaka, where shopkeepers still write sales in dusty ledgers and customers rarely ask for receipts, Bangladesh's tax collectors face a peculiar version of the "who goes first?" problem. With only 2.4 million tax returns filed in a country of 180 million, being a diligent taxpayer feels rather like bringing a calculator to a magic show – technically correct, but somehow missing the point.

The NBR's latest move to raise VAT rates to 15% might just make this collective action problem worse. As one Puran Dhakaiya trader friend of mine who deals in Sanitary ware quipped, "Why should I pay more when my competitor next door hasn't paid anything for twenty years?" It's the economic equivalent of trying to start a slow clap in an empty auditorium – someone has to go first, but nobody wants to be the lone fool clapping.

This reluctance creates a self-fulfilling prophecy. High-income professionals dodge taxes because business owners do. Business owners evade because corporations do. Corporations complain about informal businesses. Meanwhile, the few compliant taxpayers feel increasingly like the only guests who brought a gift to a "no presents please" party.

The solution might lie not in squeezing existing taxpayers harder, but in making compliance so widespread that evasion becomes the awkward choice. After all, even in Dhaka's traffic, someone eventually has to stop at the red light. Once they do, others follow suit.

The vanishing act

History suggests that when governments try to dramatically increase the burden on existing taxpayers, many simply disappear. Sri Lanka's decision to double corporate tax rates to 30% in 2022 led to a swift exodus of foreign investment. Vietnam learned similar lessons in the early 2000s, watching businesses flee to neighbouring countries with gentler tax regimes. And no, this does not apply to MNCs only, just ask your friend in audit firms how many books do Bangladeshi apparel manufacturing and general trading firms maintain. And why are so many apparel manufacturers design hubs are in the Dubai free trade zone.

"The problem with aggressive tax deepening is that it creates a powerful incentive for sophisticated avoidance," says Rahul Mehta, a tax policy expert at the Asian Development Bank. "Businesses don't just sit there and take it. They restructure, they offshore, they downsize below thresholds, or they simply stop reporting accurate numbers."

The evidence backs him up. Pakistan's attempted tax base deepening in 2019-21 led to a surge in business closures and a blooming informal economy. Revenue targets remained stubbornly unmet. Indonesia, Malaysia and Thailands aggressive tax raids in the late 1990s post the Asian Financial Crisis pushed many businesses into the shadows, taking their tax contributions with them.

A Better Way

Friedrich Hayek and Milton Friedman, those patron saints of free-market economics, long argued for broader, flatter tax systems. Their insights seem particularly relevant for developing economies today. Estonia offers a compelling example: its flat 20% tax rate and digital-first administration have produced enviably high compliance rates and steady economic growth.

The key, it seems, is to make compliance easier than evasion. "When you raise rates too high, you make honest business unnecessarily expensive," notes Sarah Chen of the World Bank's tax policy division. "But when you keep rates moderate and make compliance simple, businesses often choose to stay in the system."

Some countries are finding creative solutions. India's GST reform, despite its initial hiccups, has successfully used technology to broaden its tax base. The country's unified digital payments system has brought millions of transactions into the formal economy. Rwanda's mobile money integration with tax systems has similarly expanded the tax net while keeping compliance costs low.

Rotten to the core

Administrative corruption within the National Board of Revenue (NBR) remains a significant obstacle to effective tax collection in Bangladesh. Field-level tax officials often collude with businesses to reduce tax assessments in exchange for unofficial payments, creating a parallel system of negotiated settlements that drastically reduces actual revenue collection.

The problem is particularly acute in VAT administration, where businesses regularly face harassment during refund claims and routine audits. A 2023 survey by the Metropolitan Chamber of Commerce found that 78% of businesses reported having to make unofficial payments to resolve tax disputes or expedite refunds. The average processing time for VAT refunds remains at 160 days, despite official guidelines mandating completion within 90 days.

The NBR's resistance to complete digitization compounds these issues. Despite investing over Tk800 crore in various automation projects since 2012, critical processes remain paper-based. The automated VAT system, for instance, still requires manual verification at multiple steps, creating opportunities for rent-seeking behavior. This deliberate maintenance of manual processes has effectively created a two-tier system: one official, the other unofficial.

The impact on revenue collection is substantial. Conservative estimates suggest that collusion between tax officials and businesses results in annual revenue losses of approximately Tk20,000 crore. The new VAT rate increase to 15% may paradoxically worsen this situation by increasing the potential "savings" from unofficial settlements.

The trickle down effect of bailing out failing banks and the implication of laundering loan money by big businesses is also not remiss, but infact demands an entire article in itself.

The Three-Piece Suit of Reform

Successful tax reform in developing economies appears to need three key elements: technological infrastructure, gradual implementation, and aligned incentives. Countries that have managed this trinity—like Georgia and Estonia—have generally succeeded in broadening their tax bases without triggering capital flight or driving businesses underground.

Bangladesh's current approach, by contrast, risks achieving precisely the opposite of what it intends. The sharp VAT increase could push businesses into informality just when the economy needs more formal sector growth. The removal of exemptions on industrial inputs might save some revenue in the short term, but at the cost of making domestic manufacturing less competitive.

"It's like trying to get more milk by squeezing the cow harder," says Mohammed Rahman, a former NBR official who now consults for the World Bank. "At some point, the cow either runs away or stops producing milk altogether."

A Taxing Conclusion

The evidence from around the world suggests that sustainable tax reform in developing economies requires patience and pragmatism. The focus should be on bringing more entities into the tax net while keeping individual burdens manageable. This might mean accepting lower revenue in the short term—a difficult pill to swallow for governments under IMF pressure—but it's likely the only way to build a sustainable tax base.

For Bangladesh and other developing economies, the choice between deepening and broadening their tax bases may seem like a technical decision. In reality, it is a weird mish-mash of economic vs political reality. As they contemplate their options, they would do well to remember that in taxation, as in medicine, first do no harm. And second, if the Interim Government indeed has reform in its agenda, why incur the wrath of millions of good samaritans but overlook mending the broken taxation system?

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