Tax Revenue Potential and Effort in Ethiopia: a Comparative Analysis of Stochastic Frontier Analysis vs Utility Maximisation Function as a New Measure of Tax Effort

Abstract

This article tests the new measure of tax efforts following Dalamagas et al (2019) who argued that in the context of the Arrow-Debreu economy, with fixed labour supply and no savings, disposable income is equal to private consumption, a utility function with two arguments, income, and government spending, is maximised concerning direct and indirect tax rates. The optimal level of tax revenue is derived from a utility maximisation process and is shown to be equal to the difference between income and consumption. As a robustness check, the results of the utility maximisation function were compared to the findings of the stochastic frontier model. Each model records very near results for tax effort, tax potential, and tax gaps. The empirical findings revealed that Ethiopia has a large tax gap and poor tax effort, which is primarily due to policy choices and enforcement procedures.