Financing the Developmental State: Tax and Revenue Issues

Alice SindzingreResearch Fellow, National Centre for Scientific Research (CNRS,

Paris)/Research Centre EconomiX-University Paris X-Nanterre; Research Associate, School of Oriental and African Studies (SOAS), Department of

Economics, University of London

Presentation at the Overseas Development Institute (ODI), London

Wednesday 5th April 2006

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Questions

The concept of the developmental state; conditions of its emergence and consolidation.

The modes of financing of the developmental state: taxation and spending: major problems in LDCs.

Financing and taxation systems: institutions. Classical ingredients of effective institutions: credibility and

trust between the state and civil society .

Constraints: domestic and international, political and economic.

Foreign investors: LDCs as providers of natural resources; SSA perceived as a risky region . IFIs as ‘lock-in devices’, substitutes for domestic policies that became non credible.

Political economy, institutional processes: drying up of external financial flows, domestic savings, investment, capital flight.

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Two main arguments

• Taxation systems - via indicators such as tax/GDP ratios, levels and structure - insufficient to explain the determinants of a developmental state.

Lessons of Asian developmental states: state intervention, but under the form of policies committed towards growth, more than under the form of ownership of important shares of national assets, large levies, recycling of national wealth.

• For a policy or an institution to be effective, it needs to be credible, perceived as a commitment: endogenous processes.

Effective and credible states and institutions often lacking in LDCs, especially in SSA.

Key problem: IFI programmes and aid not well-equipped for building domestic effective institutions, policies and commitments towards growth, and endogenous processes (e.g., trust between governments and citizens).

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Outline• 1. Main features of the concept of the developmental state.

• 2. Traits of the developmental state, taxation issues, credibility, ‘anti-developmental’ rulers.

• 3. Main constraints regarding taxation in SSA: trade-based taxation; public spending and growth (social policies).

• 4. Effects of IFIs programmes: reforming financial government agencies, reducing fiscal deficits; fiscal effects of trade liberalisation.

• 5. Current limits of aid in the building of effective and developmental taxation systems and states: fiscal effects of aid; aid dependence as an obstacle to the developmental state.

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1. The concept of the developmental state• Spectacular growth of North-East Asian late industrialisers

(Japan, Korea, Taiwan): active development strategies, industrial policies (‘entrepreneurial’ states).

• Industrial policies: targeted taxation, protection, limitation of foreigner shareholding, incentives for the banking sector and firm financing, training in technology.

• Long-term relations political power-private sector.• State intervention, political rent-seeking, but public policies

tuned to market sanctions, i.e. export performance.• Intervention of the state under the form of credible and

growth-oriented policies, not of the ownership and direct control by the state of large pieces of the economy.

• No reliance on high levels of tax collection, no massive redistribution and transfers

Government spending in Asian states: an irrelevant proxy for state intervention: low tax/GDP ratios, initially limited redistributive capacities.

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• The ‘founding fathers’: necessity of government intervention. • Instruments: public policies and public institutions; both must

be credible for being effective. • At early stages of development government intervention

required for the reallocation of resources and factors, capital and labour, which markets alone cannot achieve, only in a sub-optimal way.

• State intervention necessary in order to create the conditions for coordination between sectors and economic agents and facilitate learning processes (Rosenstein-Rodan, Hirschman).

• ‘Getting relative prices wrong’: but conditional on developmental objectives.

• Ingredients of growth cannot be considered in isolation: the combination of economic, political, social factors resulted in development outcomes: ex post.

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2. Financing the developmental state

Dimensions of taxation• Taxation: a dimension of the developmental state: structure,

organisation of taxation: intrinsic aspects of state formation. • Taxation: an important factor of growth • Positive relationship between per capita income and

government spending (‘Wagner law’).• In low-income countries/LICs, the average ratio of

government spending to GDP during the period 1999-2003: about 29% (34% for middle-income countries, 42% in OECD countries).

• The tax ratio (tax revenue/GDP) varies widely in LICs.• In the past decade it rose by only 0.5 points in LICs (to around

15%). In the 1990s, 6.8% in Uganda, 8.1% in Madagascar.• In LICs, for the IMF, a tax ratio of at least 15%: an

appropriate target.

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• Asian DS: not Western style welfare state democracies.• Low tax to GDP ratios, lower than in SSA (in 1990 and

2003, current revenues in the East Asia-Pacific region averaged 12 and 11% of the regions’ GDP ).

• Key issue: policies and allocation of incentives to specific sectors that contribute to growth.

• The redistributive capacities of states that recycle only about 10% of the national wealth obviously limited in the context of predatory, clientelist politics, and in the absence of developmental objectives.

These limited capacities challenge the credibility of the state vis-à-vis the citizens.

• Key dimension of the Asian DS missing in SSA: the capacity of making public-private alliances, promoting private firms, be it for motives of collusion or personal enrichment.

• In SSA, little support to the private sector: political economy reasons, rulers feeling threatened by its autonomy.

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Ingredients of the DS: policies, credibility, legitimacy• DS: economic and political phenomenon: policies linked to

political objectives and interests, political support.• Political economy theories of taxation (self-interested rulers,

rent extraction, predatory states ).• Democracy and growth? different conclusions.• The DS model: authoritarian regimes?‘strong state’: capacity to credibly commit, implement policies,

change property rights, provide incentives for private and public agents.

In SSA, mixed outcomes of democracy: e.g., social polarisation .• Question: ingredients of trust citizens/the state? limited by the trade off between policies oriented towards

growth (investment) and social, poverty reduction policies.• Vicious circles in SSA: lack of credibility of the state, lack of

trust from citizens tax evasion further scarcity of resources incapacity of states to provide basic services increases the state’s lack of credibility.

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• State redistributive capacities limited by informal sectors. However, more a continuum than a binary dichotomy:

informal firms also pay taxes.

• The issue of ‘anti-developmental’ rulers with a long term horizon.

Growth implies a threat (uncontrolled resources, challengers).Here taxation is irrelevant (resources based on extraction)

(Acemoglu and Robinson).

• The DS: coordination, public-private sector, coalition of rulers, elites and interest groups, long term growth being of the interest of all, even through collusion and corruption.

Kang on Korea: political and economic groups in a mutual-hostage situation.

Typically, opposite political economy in LICs: the ‘divide and rule’ principle.

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3. Features of taxation in low-income countries: the case of Sub-Saharan Africa

The constraints on revenues: trade-based taxation, commodity dependence and price volatility

• Public revenue constrained in LDCs because it relies on external trade: • N Kaldor: “Will Underdeveloped Countries Learn to Tax?”: incentives for

collecting taxes (basic functions of the state), undermined by an over-reliance on external resources.

• In SSA, exports of primary products: an important share of revenues; commodity dependence; price volatility.

• Narrow industrial base, economy based on agriculture and services.• Poverty, weak institutions, political economy, informational problems, limit

possible options: tax bases go from ‘easy to collect’ taxes (e.g., tariff) towards ‘hard to collect’ taxes (e.g., VAT, income tax).

Taxes levied on export crops (cocoa, coffee, cotton, etc.) E.g., Ghana, average tax rate on cocoa in the 1990s (58%): double of its level in

the 1900s (24%) (F Teal). Stabilisation boards: redistributive functions rarely achieved.• Theory: taxation of export commodities associated with tariffs on imports

(protecting import-substitution industries): possible immiserizing growth.

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• SSA: heavy reliance on trade taxes for government revenue: between a quarter/a third of government revenue.

Cf high-income countries tariff revenues: less than 2% of tax revenues.

Commodity price volatility: dramatic impact on public revenuesUNCTAD: SSA exports experienced twice the volatility in terms

of trade that East Asia’s exports in the 1970s, 1980s and 1990s, and 4 times the volatility experienced by the industrial countries.

• A ‘natural resource curse’ ? Lack of primary commodities: a determinant of developmental states in Asia? (R Auty); commodity dependence preventing state-building, incentive for corruption, associated with high inequality?

• IMF: VAT more developmental and neutral tax. But introduction of the VAT problematic in LICs: large informal

sectors, political economy problems.

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Public spending and growth in low-income countries and developmental states

• Developmental states: no large governments: 1980-1997 period, average level of government spending of Korea: 20% of GDP

• Public sectors in SSA not excessive.• Key aspect of public spending: the macroeconomic context:

stability, policies.• SSA governments: structural fiscal deficits because of the

volatility of revenues:Increasing share of the wage bill at the expense of investment

and maintenance spending: detrimental effects.• IMF/WB stabilisation programmes: diminution of the wage

bill, retrenchment of civil servants: mixed outcomes.

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• PRSPs/IFIs: allocation of public expenditure to the social sectors; importance for growth of the composition of public spending .

• Crucial question: whether spending in social sectors is conducive to growth.

• Positive effects of social spending on growth: controversial: many intermediary processes, leakages.

• Not only composition, but also efficiency of social spending more important than its levels.

• Some studies: positive relationship between public spending and the health status of the poor.

• But other studies: weak relationship between spending on education and health and outcomes (L Pritchett).

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• Key developmental dimension regarding trust, credibility: effective redistribution, management of individual risks that push into poverty = social protection.

• Asian DS: not high levels of public spending on social protection: state, market and family structures.

• Asian DS: political use of the provision of social welfare. Governments’ political motives: strengthening legitimacy, building political support.

• H J Kwon (Korea): ‘productivism, selective social investment and authoritarianism’.

Social protection incorporated in the developmental strategy: private sources of welfare, limiting the reliance on the state.

• SSA: limited social security; provided by social networks.But ‘informal’ social protection may be inefficient, lock

individuals (group membership), distrust vis-à-vis the state.• Relationship between low inequality and growth?Asian DS reduced inequality legitimating the DS.In contrast, many LICs characterised by high after-tax inequality.

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4. The consequences of reform on the formation of developmental states in SSA: stabilisation, structural

adjustment programmes, PRSPs

Reforming financial government agencies, reducing fiscal deficits

• Autonomous agencies for revenue collection: mixed effectiveness; political economy problems.

• Recessive aspects of IMF stabilisation programmes; but the deficit-growth nexus: nonlinear.

• Regarding revenues, IMF: the experience with tax policy during the 1990s was mixed.

• Context of weak states, instead of enhancing coordination, IFIs over-optimism about the minimal state (provision of public goods, macroeconomic stability).

Left aside ingredients of state-building of the DS (and the ‘Scandinavian model’), ‘more state and more market’.

• Reforms also assumed a better efficiency of private entities.In SSA, privatisation not always efficient.In Asian DS, transfers of state assets by bureaucracy, politicians and businessmen

linked by mutual interests (‘collusion’).In SSA, private sector: too often, informality, antagonism vis-à-vis the state.

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The fiscal effects of trade liberalisation• Trade liberalisation: negative impact on SSA: reliance on

trade taxes. • Gupta (IMF): decrease in trade taxes in SSA between the early

1990s and the early 2000s: from 4.9% to 3.5% of the GDP for the import duties, and from 1% to 0.4% of the GDP for export duties.

• Early 1990s: tax revenues in SSA, 16.3% of GDP; 15.9% in the early 2000s.

• Criticisms: reforms should stimulate savings and investment.• Trade liberalisation in SSA: mixed results: not a basis for long

term growth; no reduction of vulnerability to external shocks, no diversification of exports from natural resources.

• E.g. Ghana: reforms did not address a source of failure: the heavy taxation of agriculture (cocoa) (F Teal).

• ‘Fiscal squeeze’ : reduction of the capacity of public policies towards export diversification (costly) and spending on infrastructure: though crucial for the DS.

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• Lowering corporate taxes, intensified international tax competition, rush to attract FDI

But Asian DS were cautious /openness to FDI.• SSA: trade liberalisation: often exacerbated fiscal difficulties.• IMF: revenue losses recouped from domestic indirect taxes?

VAT?But revenue recovery very weak in LICs (most dependent on

trade tax revenues): IMF study: only 30% of losses .IMF studies: uncertain revenue implications of trade

liberalisation.Combining tariff cuts with a one-for-one increase in consumption

taxes or increases in consumption taxes? The sequencing and implementation: very delicate .• But: the negative relationship between trade liberalisation and

revenues not always found. • Tension fiscal consolidation vs. trade liberalisation (which

may hinder the maintenance of industrial sectors) (IMF vs. WB).

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5. The effects of aid in terms of taxation and building the developmental state

• Can any developmental state be built via aid (Asian DS benefited from aid).

• The amount of aid is not enough: at early stages of growth, what is needed is not only external financing but long term strategies for an efficient reallocation of factors and coordination devices.

=key role for the state, its capacity to implement credible policies and reallocations.

• Easterly’s critique of aid surges, ‘big push’: Asian countries grew gradually, without any ‘big push’ provided by aid .

• Shift to budget support; PRSPs: allocation of revenue to poverty reduction. • Heated controversy about the effectiveness of aid. Broad consensus that ‘aid works’But many sceptical views regarding the recent commitments of donors to

increase aid (especially to SSA)Doubts about aid effectiveness expressed at the IMFRajan and Subramanian: aid has a negative relationship with growth, particularly

in aid-dependent countries (overvaluation of the exchange rate, hinders competitiveness).

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The fiscal effects of aid• Well-known tension conditionality vs. ownership. The incentive mechanisms provided by conditionality (ex ante and based on

action) and ownership (ex post and based on outcomes) not easily distinguishable (Dixit).

• Moss and Subramanian (2005): if states rely on donors for finance, ‘why bother to tax your own citizens’?

Aid provides incentives for reducing the tax effort, lowers the incentives to broaden the tax bases and reduce aid dependency.

• Gupta (IMF): key issue: composition of aid. Repaying loans leads to increased domestic revenues: concessional loans

associated with higher domestic revenue. Grants: opposite effect.• More general issue: the fungibility of aid; e.g., using aid for recurrent

expenditures.Aid dependence, aid fungibility, aid volatility: detrimental effects on revenues

and on the consolidation of state capacity. • Ongoing debate: whether loans or grants would be optimal means.Key issue: whether projects have the level of returns that would not aggravate

fiscal deficits. But aid finances through grants projects that have high social value but

uncertain returns, e.g. education and health.

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• McGillivray and Morrissey on fiscal response models: aid may discourage tax efforts or encourage increased borrowing;

but aid may increase tax efforts, encourage increased spending on investment, and support improved fiscal management so reducing borrowing.

=mixed results.

• IMF: cautious towards aid and the aid increases promised for SSA.

Gupta et al: mixed empirical evidence on how aid flows affect domestic revenue collection, but often negative.

IMF: the scaling up of aid: important impact on revenue mobilisation:

Governments may view aid as substitutes for domestic revenues.

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Aid dependence as an obstacle to the developmental state

• In LICs, aid: major source of external finance since the 1970s. Between 1970-75 and 1991–95, aid as a share of GDP in LICs

increased from 6% to 15%; private capital inflows (including FDI) fell from 2 to 1 % of GDP (Morrissey).

• Aid dependence: negative effects: volatility, unpredictability of aid flows, problems of capacity of absorption.

• Bulir and Hamann: volatility of aid much higher than that of revenue and increased in the late 1990s.

The average volatility of aid is 40 and 20 times higher, respectively, than that of revenue when expressed in percent of GDP and constant U.S. dollars per capita.

Relative volatility of aid is the highest in the least and most aid-dependent countries, defined as having aid-to-revenue ratios of less than 25% and more than 50% respectively.

• Aid also unpredictable: Bulir and Hamann: aid delivery falls short of pledges by more than 40% (esp. for poorest countries).

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• IMF: aid dependency accentuated by the programmes of poverty reduction, higher spending in social sectors.

The goals of poverty reduction, surge in aid: risks for the prospects of building developmental states in SSA.

• IMF: moderating aid inflows, limiting primary deficits, increasing taxation, curbing aid dependency

Vs. WB: may support aid inflows.

• Problems inherent with aid: it is external, with a multiplicity of players non cooperative games.

E.g., MTEFs resulted from assessments of the deterioration of budget institutions in SSA, and the responsibility of aid as a major part of budget financing in the fragmentation of the budget and the distortion of budget priorities.

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• Aid dependence: weakening of institutions. It weakens the credibility of governments and their policies,

therefore weakens political institutions and their legitimacy.• Moss et al. (CGD): increases in aid to SSA: negative effects on

state revenue and on political institutions. Aid dependence transforms the state-citizens relationship: if

governments raise their revenues from aid, they become more accountable to donors than to their citizens.

No need to build legitimacy nor devise credible policies, effective institutions.

Erodes the developmental state? • Questions: - How to identify the ingredients of credibility and commitment of

a government, and of a right composition of policies, which are credible, politically feasible, effective in terms of growth.

- Can external assistance have a role, if these processes are endogenous?

- Conditions for building a ‘fiscal contract’ ? (FIAS-DFID study)

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Conclusion/summary• Constraints on taxation in SSA: dependence on external trade.Trade liberalisation: mixed outcomes, mixed contribution to

conditions for DS. • Aid: incentives that may undermine tax structures and state

institutions (policy credibility, legitimacy).• Two arguments. - Asian DS: capacity for a state to credibly commit and intervene,

under the form of policies that are directed towards growth, not policies that recycle the national wealth through taxation.

=capacity to address coordination failures and to reallocate factors of production, coalitions between the state, private firms and the civil society.

Political dimensions: growth instrumental in the building of political support

- For a policy or an institution to be effective, it needs to be credible and perceived as a commitment: endogenous processes.

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Questions

- can external players (IFIs, donors) contribute to the building of effective institutions and policies, as well as to developmental taxation?

- Can donors only create the conditions for these developmental processes to emerge?