Banks, development, and tax

The modern agenda for tax reform in developing countries prescribes a broader tax base, with increased reliance on income taxes. To be feasible, governments must be able to broadly monitor receipts of income, a challenge in countries with opaque financial systems. The present work considers the financial sector – specifically the banking sector – as a boon for tax revenue. Historically we find that larger banking sectors are associated with more tax revenue. To better understand this relationship we set up theoretical models of it, with a role for public good preferences, population size, the tax rate on deposits, the opportunity cost of cash spending, and money velocity. In these models, governments can raise more tax by making banking more attractive, via infrastructure that raises deposit velocity or by lowering the marginal tax rate.