An essay on taxation, governance, institutions and economic incentives
Inspired by tweet posted by Prof. Alemayehu Geda.
Prof. Alemayehu Geda is right to call attention to Ethiopia’s tax regime, tax administration, tax revenue and, particularly, the incentive effects of taxation. The concerns being expressed by businesses—large and small—deserve urgent and serious examination. A tax system that discourages investment, encourages businesses to close or move into the informal economy, and undermines entrepreneurship ultimately defeats its own purpose.
But I would argue that it is difficult to examine Ethiopia’s current tax problem in isolation. The tax burden is only one part of a much larger problem of economic mismanagement, institutional deterioration, corruption and declining standards of governance. Unless these underlying issues are addressed, reforming tax rates alone is unlikely to produce the desired results.
From institutional inertia to institutional erosion
For much of the period following the imperial era, Ethiopia benefited from an institutional and bureaucratic framework that, despite its serious political limitations, provided a degree of continuity and administrative competence. The state inherited a technocratic tradition in which a number of ministries, professional services and public institutions functioned as centres of expertise. These institutions were far from perfect, but they provided the machinery through which the country could be administered and its basic functions maintained.
The Derg subsequently weakened many of these institutions. Yet much of the institutional damage can be understood as a consequence of the regime’s ideological and political struggle with the educated and professional classes who had staffed and developed them.
The more consequential change came after the EPRDF/TPLF assumed power in 1991. The new political order increasingly subordinated institutions to the requirements of political control. Instead of allowing professional competence and institutional independence to serve as the primary basis for advancement, political loyalty and affiliation increasingly became important determinants of access to power and economic opportunity.
This distinction matters. Institutions can deteriorate through neglect, incompetence and political upheaval. But they can also be reshaped to serve a political system. When that happens, institutional weakness becomes embedded in the system itself.
The decline of meritocracy
One of the most damaging consequences was the gradual erosion of meritocracy.
A modern economy depends on institutions in which competence, professional integrity and predictable rules matter more than political connections. Once people begin to believe that advancement depends primarily on whom they know, which political network they belong to, or which regional or ethnic affiliation they can mobilise, the incentives of the entire society begin to change.
The ethnic-based federal political system added another layer to this problem. In principle, federalism can bring government closer to citizens and allow different communities greater political representation. In practice, however, the politicisation of ethnicity created an environment in which political, administrative and economic opportunities could become closely associated with regional and ethnic affiliation.
The result was not simply a political problem. It affected the economy.
Access to land, credit, government contracts, employment and other economic opportunities increasingly came to be perceived as dependent on political connections and affiliation rather than solely on competence and merit. Nepotism, cronyism and rent-seeking could therefore become rational strategies for economic advancement.
Once such behaviour becomes widespread, corruption ceases to be merely an individual moral failure. It becomes an institutional incentive.
The transformation of incentives
This may be one of the most important aspects of Ethiopia’s current crisis.
A society does not become deeply corrupt simply because individuals suddenly become less honest. Corruption flourishes when institutions make it advantageous, or even necessary, to behave corruptly.
When the rule of law becomes uncertain, when government decisions are unpredictable, when access to economic opportunities depends on connections, and when public officials have considerable discretionary power without effective accountability, citizens adapt to the system.
Businesses learn that paying unofficial fees may be necessary to survive. Individuals learn that connections can be more valuable than qualifications. Officials learn that their position gives them opportunities for rent extraction. And citizens gradually lose confidence that following the rules will put them at an advantage.
This creates a vicious cycle: institutional deterioration produces corruption; corruption further weakens institutions; weakened institutions make corruption more attractive; and the resulting loss of trust makes effective governance even more difficult.
The political cost of an oversized political machine
There is another dimension to the problem that is rarely included in discussions of Ethiopia’s tax burden: the cost of maintaining the political machinery itself.
The Prosperity Party has publicly described itself as having more than 14 million members, and later reported membership of 15.7 million. Such a vast political organization does not operate without resources. Maintaining its structures, personnel, administration and political activities inevitably carries a significant economic cost.
The concern becomes considerably more serious when political networks overlap with the administrative and commercial system. Where party-affiliated or politically connected individuals are able to use public authority to pressure businesses or ordinary citizens for money, favours or other benefits, the distinction between taxation, rent extraction and outright corruption becomes blurred.
For a business owner, the practical distinction may be almost irrelevant. Whether money is demanded as an official tax, an administrative payment, an unofficial fee or a payment to avoid an invented bureaucratic obstacle, it is still a cost of doing business. And unlike a statutory tax, such payments are often unpredictable, unrecorded and impossible to incorporate into a rational business plan.
This creates what might be called a parallel tax system—one that does not appear in the government’s tax statistics but nevertheless reduces the resources available to private enterprise.
The state must therefore be judged not only by how much revenue it formally collects, but also by how much economic value is lost through rent-seeking, corruption, political patronage and administrative abuse.
The emergence of a parallel system
The situation appears to have deteriorated particularly sharply in recent years.
What we increasingly see is not simply inefficient government, but the coexistence of a formal system and an informal one.
The formal system consists of laws, regulations, taxes, government agencies and official procedures. Alongside it, however, businesses and citizens increasingly encounter informal demands, unofficial payments, political intermediaries, personal networks and discretionary decisions that are difficult to reconcile with the formal rules.
This is especially relevant to the tax debate.
It is easy to compare Ethiopia’s statutory tax rates with those of other African countries and conclude that Ethiopia still has room to increase taxation. But such comparisons can be profoundly misleading if they consider only the formal tax system.
A business does not experience taxation as a percentage printed in a tax code. It experiences the total cost of dealing with the state: formal taxes, customs duties, licences, inspections, compliance costs, delays, arbitrary assessments, unofficial payments and other costs associated with operating in an unpredictable administrative environment.
The effective burden can therefore be dramatically higher than the statutory tax rate suggests.
This is why the concerns being raised by Ethiopian businesses should not simply be dismissed by pointing to Ethiopia’s relatively low tax-to-GDP ratio or comparing its formal tax rates with an African average. The relevant question is not simply, “How much tax does the government officially collect?” It is also, “How much does it actually cost a business to operate within the Ethiopian state?”
That distinction may prove crucial to understanding why businesses are closing, reducing investment or moving into the informal economy.
Spending priorities matter too
The other side of the equation is government expenditure.
Increasing taxation can only be justified economically when citizens and businesses can reasonably expect that the additional revenue will be transformed into productive public investment and better services. If scarce public resources are instead absorbed by an expanding political and administrative apparatus, or directed toward highly visible projects with limited economy-wide transformative impact, the justification for continually increasing the tax burden becomes much weaker.
This does not mean that urban beautification, corridor development or similar projects have no value. They can improve mobility, public spaces and the quality of urban life. The question is one of priority and opportunity cost.
At a time when Ethiopia faces severe shortages of foreign exchange, weak private investment, unemployment, declining purchasing power and widespread business distress, every birr spent by government should be evaluated against alternative uses that could raise productive capacity—power generation, industrial infrastructure, agricultural productivity, logistics, education, health, export capacity and support for productive private investment.
A government cannot continually ask a struggling private sector to pay more while failing to demonstrate that public expenditure is being allocated with the same discipline demanded of taxpayers.
Taxation cannot be separated from governance
This brings us back to Prof. Geda’s important observation.
Ethiopia certainly needs a serious examination of its tax system. But the study should go beyond tax rates and revenue collection. It should examine the relationship between taxation, economic incentives, institutional quality, corruption, administrative discretion and business survival.
The objective of increasing the tax-to-GDP ratio should not be pursued mechanically. A government can increase tax collection in the short term by imposing greater burdens on existing taxpayers. But if those policies cause businesses to close, discourage investment, push economic activity into informality and reduce employment, the apparent increase in revenue may ultimately undermine the tax base itself.
The fundamental question, therefore, is not simply how much more tax Ethiopia can extract from its economy.
It is whether Ethiopia can rebuild an economic and institutional environment in which people are willing to invest, businesses can operate predictably, professionals are rewarded for competence, public officials are accountable, and citizens once again have an incentive to follow the rules.
Without that transformation, tax reform risks treating the symptom while leaving the disease untouched.
Editor’s Note: Views in the article do not necessarily reflect the views of borkena.com
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