The hidden unfairness in your tax system and how to fix it

In many developing countries, two people can earn the same income and pay very different amounts of tax — not because of different rates, but because of how they earn their money. If one is a salaried employee and the other is self-employed, the employee is likely to pay far more. Our new research suggests that such inequality within the same income group is not only widespread, but it is undermining the political viability of tax reform, because the self-employed can more easily underreport income for tax purposes and salaried workers are unlikely to accept being taxed more.
 

The gap is large, and it sits at the top

In a new World Bank Policy Research Working Paper we measure how much more tax employees pay compared to the self-employed in 25 low- and middle-income countries using micro-tax simulation models. The findings are striking. In the top income decile, where the self-employed make up nearly half of all earners, compared to just 10 percent in high-income countries, a self-employed individual pays approximately 36 percent less in taxes than a salaried peer with identical income. This gap is not a rounding error but a structural feature of how tax systems work in many developing countries.

When someone is employed, their employer withholds taxes directly from their paycheck. Third-party reporting makes evasion difficult. The self-employed, by contrast, report their own income, and in countries where enforcement capacity is limited, underreporting is both common and largely unchecked. The tax system ends up being less about what you earn and more about how you earn it.
 

A sharp trade-off in tax design

Most governments are advised to shift from consumption taxes like VAT toward personal income taxes, because income taxes are considered more fair: richer people pay more than poorer people. But this paper shows the trade-off is more complicated.

A budget-neutral reform that raises income taxes while cutting consumption taxes does improve progressivity across income groups — the rich pay more relative to the poor. However, it significantly worsens equity within income groups, because it is mostly salaried workers who actually end up paying more. Self-employed individuals at the same income level continue to underreport and largely escape the net. The reform that looks progressive on paper can deepen unfairness in practice.

Tax Policy Tradeoffs of Horizontal and Vertical Equity

Note: This figure shows the results of a budget neutral reform that raises 1% of GDP from PIT rebated through VAT cut. The increase in PIT revenue arises from changes in the marginal tax rates paid by top-decile households to simulate a progressive tax reform.

Here is what may be surprising: consumption taxes (taxes on what you spend, like sales tax), treat employees and self-employed workers more fairly than income taxes do. That is because people at similar income levels tend to spend their money in similar ways, regardless of whether they work for a company or for themselves, meaning consumption taxes affect both groups roughly the same. The salaried worker and the self-employed peer end up bearing a more equal tax burden. The paper shows that how fairly taxes are distributed and who actually pays them are linked and must be considered together.
 

Citizens know something is wrong — but want enforcement, not a tax switch

To understand how citizens perceive these inequities and what they want done about them, we conducted large-scale surveys of over 17,600 respondents across six middle-income countries, including Pakistan.

When people were told the actual size of the gap, for instance, that salaried workers in Pakistan pay four times more in income tax than self-employed individuals with similar earnings, their concern increased sharply. The information mattered. People were not indifferent to unfairness across worker types; they simply did not know how large it was.

The revealing part is that learning about the gap did not shift people’s preferences toward consumption taxes as a policy fix. Those who became more concerned about the inequity also believed that the government could reduce evasion if it genuinely tried. Their conclusion was not that the tax mix was wrong, it was that the system was being poorly administered.

This reflects an important political logic. If citizens see that income taxes fall disproportionately on easy-to-tax employees while the self-employed go largely untouched, they will resist any reform that raises income taxes further. In such an environment, efforts to bring more taxpayers and income into the formal tax system will only succeed when enforcement improves alongside them.
 

What this means for tax reform

Large inequities across worker types are not just a fairness problem. They create the perception, grounded in reality, that the burden of any new reform will fall on those who already bear the most. That perception becomes a constraint on any reform process before it even starts.

For base broadening to succeed, governments need to pair changes to tax schedules with visible and credible improvements in enforcement capacity. Technology offers practical tools here: third-party reporting, digital invoicing, and data integration between revenue authorities and financial institutions are the mechanisms through which equity across worker types can be improved in practice.

The paper also notes that the same logic applies beyond the self-employed versus employee divide. International tax avoidance and the preferential treatment of capital income over labor income generate similar inequities, and similar political resistance.

Fair taxation starts with the perception that everyone is playing by the same rules. Where that perception is absent, reform will be hard.

Source : World Bank