European Online Journal of Natural and Social Sciences 2015; www.european-science.

com
Vol.4, No.1 Special Issue on New Dimensions in Economics, Accounting and Management
ISSN 1805-3602

Estimation of the Taxable Capacity: The Case study of a Developing Country

Shahram Fattahi1, Mahdi Shokrinia2, Mehrdad Jaihonipour3

1
Faculty of Social Sciences, Razi University, Shahid Beheshti Blvd, Kermanshah, Iran;
2
Iranian National Tax Administration; 3Askariye Credit Institution
E-mail: sh_fatahi@yahoo.com

Abstract
Existence of an effective tax system is essential for economic development. This paper
estimates taxable capacity on occupations in Kermanshah province, Iran, for the period 1993-2007.
The results indicated that average rate of tax effort in occupations sector is more than 0.17 which
represents a tax gap in the occupations sector and the existence of potential capacities. Furthermore,
from 1000 business units in the province only 1/4 units pay taxes while the corresponding average
level of country is 3/4.
Keywords: Taxable capacity, Tax Effort, Economic Development

Introduction
Effective tax systems are essential for developing countries because they can help promote
economic growth. Due to the large budget deficits in many countries, governments have been
searching for possible ways of increasing tax revenues to finance public expenditures and narrow
the deficit without much distorting economic activities (Le et al, 2012).
In economics, some macroeconomic goals like economic growth are the government
responsibility. It is clear that every government needs budget to conduct economic policies. One of
the problems for tax system is inability to have tax capacities in the society. Awareness from the rate
of unachieved capacity of tax incomes at the level of regional economies is very important.
This paper tries to introduce and estimate taxes on occupations in Kermanshah province.
After estimating the capacity of tax on occupations, the rate of tax effort for different years is
calculated and estimated. Therefore, this study tries to specify real tax capacity in the Kermanshah
province and also to analyze the rate of achieving tax incomes for the period 1993-2007.
Organization of the paper is as follows. Following introduction in section 1, Section 2
defines what tax capacity is. Section 3 presents the literature review. Section 4 describes the
methodology used. Section 5 reports the empirical results and finally Section 6 presents the
conclusions.

Tax capacity
Taxes are the most common and important financial resource to supply public incomes and it
is one of the most influential and important tools of tax policies that government is able to offer
most of the activities, economic and social processes. Financial incomes and reaching at real
capacity of taxing in the society is the most important way to decrease reliance to the oil to adjust
exchange fluctuations. The most important one is that based on the law of budget in the country the
civil expenses in the province are totally dependent on provincial incomes and allocation of
provincial credits forms by coefficients of public incomes in the province and as more than 80% of
these incomes are allocated to the provincial incomes in the province, therefore tax incomes are used
as one important method to be equipped by developmental financial resources in the province. The
main motivation of taxing is to finance economic projects related to social services. Efforts to
collect tax incomes are determined by introducing tax tools at the level of province. More reliance

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 Shahram Fattahi, Mahdi Shokrinia, Mehrdad Jaihonipour

on tax incomes, regardless of these tools and factors affecting tax capacities, can not be successful.
One of the main strategies about taxes is to increase the level of tax effort by improving methods of
collecting taxes and establishing laws and necessary regulations. Taxes capacity provides necessary
information about economical potential in equipment tax resources and determines which factors are
the most influential ones in acquiring different types of tax incomes. Information about tax capacity
on current occupations and comparing them with taxes that will be received can help government in
the planning for budgeting based on more reliance on taxes. Precise estimation of incomes of taxes
on occupation help government to have more stable planning and rate of cooperation in this sector
will be specified in supplying public government expenses more precisely. Literature review related
to tax potential capacity in Iran indicates that there is a considerable gap between tax potential
capacity and actual tax incomes.
Tax capacity can be interpreted as the taxpayer’s ability to pay or the government’s ability to
raise tax revenue (Chun &Kuo, 2000). Therefore, factors affecting tax capacity can be divided into
two groups: Factors related to ability of individuals in paying taxes. In this case, ability of
individuals in paying taxes is determined by structural factors like level of income and intentional
factors like individual’s sense of responsibility to paying taxes. The second type is related to ability
of government in collecting and in raising tax revenue. Ability of government in collecting taxes
depends on structural factors like easy access to the tax bases and organizational efficiency of tax
collection (Karimi, Hoshiar, 2007).
It should be noted that since the correct recognition of intentional factors is difficult it is
better to focus on structural factors. For example, assuming other factors fixed the higher level of
per capita income shows higher ability of individuals to pay taxes. Also when mineral export is the
main share of national gross production, increasing of tax incomes is much facilitated.
The impact of different factors on tax capacity is different from one society to another
society. However, influential variables on tax capacity can be divided into two general sets of
quantitative and qualitative variables Quantitative variables
The most important quantitative factors affecting tax capacity include the rate of added value
of products, per capita income, income redistribution, efficiency of production factors, level of
employment and combination of employment, rate of rural and urban population, qualitative and
quantitative combination of import and export, and ratio of large economic firms to the entire
economic firms.
Although qualitative factors on tax capacity can not be precisely determined, it is possible to
refer to state of economy, recession or boom, the culture of paying taxes, rate of organizational
ability in collecting taxes, correct recognition and transparency of economic activities, independence
or lack of independence of organizations in collecting taxes, coordination of regulations and law
transparency.

Literature Review
Alfirman (2003) analyzed tax capacity in Indonesia and came to the conclusion that local
governments were far from their tax capacity and could increase their tax revenue.
Davoodi and Grigorian (2007) examined the measures of institutional quality and informal
economic activity and showed that institutional improvements as well as policy initiatives are
important in raising tax revenue performance.
Pessino and Fenochietto (2010) concluded that there is a positive and significant relationship
between tax capacity and the level of development, trade, and education.
There have been some studies done on the tax capacity in Iran. Yahyaee (1991), using the
ordinary least squares and data from 1983 to 1985, estimated the tax capacity in Iran. She
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Special Issue on New Dimensions in Economics, Accounting and Management

considered the level of per capita income, economical texture of society, and importance of different
types of economical activities, and also influential factors on ability of government in collecting
taxes like costs of appointing and collecting taxes as influential factors on tax capacity. The
coefficients of related variables are 0.001, 0.112, 0.365, and 0.482 respectively which means
positive effects on tax capacity.
Arbab (1987) analyzed tax efficiency in Iran for the period 1973-1985. To examine the
achievement or lack of achievement of tax system, different indexes are introduced and considerable
indexes were examined in two time periods, 1973-1978 and 1979-1985. The index of annual growth
of tax incomes to national income, the index of relate of governmental payments to GDP, the index
of relative of government payments to national income, index of receiving taxes to approves taxes,
the index of receiving taxes to general incomes of government and index of relative of taxes that is
the rate of entire financial incomes that is the relative of the entire tax incomes to domestic gross
production, and analyzed indexes in the research. The results showed that industrial sector and
commercial subsector of service can pay more tax and it has an impact on tax incomes.
Nikoo (1996) tried to estimate tax capacity in Hamadan province by using the econometric
models. He considered variables of export in the region, productions of province in industry sector,
productions of mine industry, productions of agricultural sector, and rate of learning education in the
province as influential variables on tax capacity. Models were tested statistically for the period
1981-1995. Among estimated different equations the equation with variables productions of
province in industry sector, productions of mine industry, productions of agricultural sector, and rate
of learning education were significant and had coefficients 0.176, -5.16, 0.006 and 354.83
respectively.
Estimating tax bases in different economic sectors, EhsanFar (2001) calculated added value
in Mazandaran province. Tax ratio or ratio of the entire taxes in the region to domestic gross
production in the region was used as a dependent variable and added value of different economic
sectors and also rate of literacy, which is used as a proxy for per capita income, were explanatory
variables. Estimating province tax capacity using time series data for the period 1971-1998 shows a
gap between potential tax capacity and actual tax incomes. The estimated coefficients of model
represents positive impacts of industrial, mining and service sectors on dependent variable and that
service sector is the most important factor. Calculating Tax capacity and tax effort, he came to the
conclusion that tax system is not efficient.
With regard to the general tax performance in Iran and calculating tax effort in East
Azerbaijan province, Safari (2001) estimated the tax capacity in this province. Tax capacity was
defined as tax volume that society has the power of paying it and tax effort are defined as the ratio
of collected taxes to tax capacity. Added value in mine and industry and service sectors were
considered as influential factors in tax capacity. Also the share of added value in different economic
sectors from GDP of province and rate of literacy as tax culture is of influential factors in tax
capacity. Finally he concluded that the rate of received tax is of the influential factors on tax
capacity in the province and the rate of received tax in the entire period is lower than estimated
capacity.

Methodology
Related Literature suggests factors like degree of economics openness, level of economic
development, combination of incomes and economic structure are determinants of the capacities of
accepting taxes. To take these factors into account, the following proxy variables are used.
Proxy variables for economics openness: ratio of import to export, the ratio of foreign trade
that can be obtained from the sum of imports and exports divided by GNP.
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 Shahram Fattahi, Mahdi Shokrinia, Mehrdad Jaihonipour

Proxy variables for the level of economic development: it is the main determinant of tax ratio
in the level of income which affects ability in paying taxes. Higher per capita income represents
higher level of economic development that itself causes higher acceptance of taxes. Rate of added
value in agriculture sector is another criterion in the stage of economic development.
Proxy variables for the combination of incomes or economic structure: mining sector has the
main role in domestic gross product. On the other hand, previous studies showed that there is a
strong and positive relationship between the share of mining sector of GDP and tax ratio.
Furthermore, added value in industrial sector has a positive relationship with tax ratio.
In this research, the data on added value in different economic sectors in Kermanshah
province are used as tax basis for the period 1993-2007.
The research hypothesis is as follows:
Tax ability (potential tax) in occupations sector in Kermanshah is more than actual taxes.
In the capacity tax function, t=T(x), it is necessary to introduce vector X. This vector
includes value added in different economic sectors.
The following alternative models are used to examine the tax capacity:
1) TPIU = a0 + a1 VSE + a2 VAG + a3 VMI + a4 x + U
2) TPIU = b0 + b1 VSE + b2 VIN + b3 VMI + b4 VAG + b5 y + b6 (X – M) + U
3) TPIU = c0 + c1 VSE + c2 VIN + c3 VMI + c4 VAG + U
4) TPIU = d0 + d1 VSE + d2 VIN + d3 VAG + d4 X + d5 y + U
where (TPIU) the index of tax on jobs in the province, (VAG) added value of province in
agricultural sector, (x) the rate of exportation in the province (VSE), added value of province in
service sector, added value of province in industry sector, added value of province in mining sector,
import(M), export and (Y) shows the rate of per capita income.

Empirical Results
Stationarity of variables
Before estimating equations it is necessary to avoid the spurious regressions. To do so, the
Dickey- Fuller test is used for the unit root.
Table (1) reports the results of Dickey- Fuller test. It is clear that all variables are stationary
in %95 level of significance.

Table 1: Results of Dickey- Fuller test

Variable Dickey- Fuller statistics Result
TPIU -3.794 stationary
VSE -6.093 stationary
VIN -3.963 stationary
VMI -3.522 stationary
VAG -3.802 stationary
X -3.270 stationary
Y -3.917 stationary
X-M -3.593 stationary

After analyzing stationary of variables, the potential capacity is calculated for business
companies in 2002 and then the results were compared to the estimated model. The same procedure
is used for the remaining years.
The tax capacity on occupations has been reported in Table 2.

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Special Issue on New Dimensions in Economics, Accounting and Management

Table 2: Total tax on occupations for different sectors (in Million Rials)
Sector Taxes of real individuals
Mine 10470
Industry 70143
Water 3946
Construction 104371
Wholesale 94347
Hotel and restaurant 14364
Transportation 77130
Mediation 20921
Sum 395670

According to added value for each sector, we conclude that tax capacity on occupations in
Kermanshah province is estimated to be 395670 million Rials. The performance of tax income on
occupations in 2002 is more than 49780 million Rials which means tax effort on occupations is
12.58%.

Estimated Model
Examining different specifications, Model showed to be the best fitting model. The
estimated tax capacity model is as follows:

TPIU =18.59 + 0.0124 VSE + 0.0757 VIN – 0.0122 VAG –0.012 X+18276.1 Y
t (2.64) (2.91) (5.59) (-3.13) (-4.51) (3.01)
2
R = 0.99 D.W = 2.1 F = 1197

To test reliability of the estimated tax capacity function, information on added value in
different economic sectors in Kermanshah province is used as tax basis. Based on calculation of
added value of business companies in every sector, the tax capacity on occupations is 395.670
billion Rials while performance of tax incomes in 2002 is more than 49.375 billion Rials. Therefore,
tax effort on occupations in 2002 is estimated to be 12.47%. It should be noted this method can
estimate tax capacity on jobs just for 2002, not for other years.
Now we compare the results from added value in 2002 with the results from the estimated
model. The values of variables in 2002 are:
VSE = 8779.3 , VIN = 1373.2 , VAG = 2713.6 , X = 752.86 , Y = 0.0078
Putting the above values in the model yields:
TPIU=18.59+(0.0124*8779.3)+(0.0757*1373.2)-(0.0122*2713.6)-
(0.012*752.86)+(18276.1*0.0078) =331.58
Therefore, the estimated capacity of tax on occupations in the province in Year 2002 is
331.58.
According to the actual tax on occupations in 2002 which equals to 49.375 billion Rials, the
effort of taxes on occupation is 14.89%. The research hypothesis is accepted and it can be said that
potential capacity of taxes on occupations is more than the actual tax. Now, we can obtain the tax
capacity on occupations and tax effort of province for the whole period (see Table 3).

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 Shahram Fattahi, Mahdi Shokrinia, Mehrdad Jaihonipour

Table 3: Estimating potential capacity and tax effort on occupations in Kermanshah province
for the period 1993-2007 (billion rials)
Actual tax on Potential capacity of Tax effort on
Year
occupation taxes on occupation occupations Tax gap
1993 5.075 34.418 0.1475 0.853
1994 7.092 42.534 0.1667 0.833
1995 8.425 58.139 0.1449 0.855
1996 12.741 83.044 0.1534 0.847
1997 22.469 102.305 0.2196 0.780
1998 25.495 113.523 0.2246 0.775
1999 28.045 152.418 0.1840 0.816
2000 37.205 211.553 0.1759 0.824
2001 36.300 249.314 0.1456 0.854
2002 49.375 331.971 0.1487 0.851
2003 60.065 409.858 0.1466 0.853
2004 80.980 517.715 0.1564 0.844
2005 105.640 628.561 0.1681 0.832
2006 140.490 798.639 0.1759 0.824
2007 187.790 1007.573 0.1864 0.814

Based on table 3, it is clear that sum of the potential tax in the occupation sector is higher
than the sum of received real taxes, therefore existence of tax gap is approved and the hypothesis of
this research is accepted.

200
180
160
140
120
100
80 year
60
40
20
0
199319941995199619971998199920002001200220032004200520062007

Figure (1): Tax performance on occupations in Kermanshah province (1993-2007)

According to Figure 1, an actual tax on occupations in 1993 was 5075 million rials that has
grown with 26.77% on average and it reached at 187790 million rials in 2007. Although the share of
the tax from the entire taxes of the province has grown appropriately, this share distances from real
figure. The reason is that although people in this sector are part of rich group, they have fewer
shares in paying taxes and their taxes are lower than state employees.

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Special Issue on New Dimensions in Economics, Accounting and Management

Conclusions
The purpose of this research was to estimate tax capacity on occupations of Kermanshah
province. The findings of this research indicated that
-Average rate of tax effort of occupation sector in Kermanshah province during the period
1993-2007 is more than 0.17 which represents tax gap in the occupations sector and the existence of
potential capacities in this sector.
-The share of added value in industry sector is larger in providing tax capacity on
occupations and shows existence of tax capacity in industry sector. Economic structure of the
province is a main factor in determination of tax capacity which can be examined through added
value of different sectors.
-Although added value in agricultural sector is in a high level, due to tax exemptions and
decreasing the share of this sector in GDP, negative coefficients of added value in this sector is
expected. As expected, the weight of foreign trade in the province has a large effect on tax capacity
and shows to what extent economic activities in the province is affected by exports. Tax capacity in
the province has a negative relationship with volume of exports. Added value in mining sector has a
negative impact on taxes on occupations, because mining sector is in the realm of governmental
ownership and is exempted from paying taxes.
-Based on the estimated models, it was proved that from 1000 business units in the province
only 1/4 units pay taxes while the corresponding average level of country is 3/4 units. Therefore by
comparing these two shares we see that table capacity on occupations in the province is more than
that of country.

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