Fiscal Policy and Economic Development

Most stabilization attempts have concentrated on cutting government expenditures to achieve budgetary balance. But the burden of resource mobilization to finance essential public developmental efforts must come from the revenue side. Public domestic and foreign borrowing can fill some savings gaps. In the long run, it is the efficient and equitable collection of taxes on which governments must base their development aspirations. In the absence of well-organized and locally controlled money markets, most developing countries have had to rely primarily on fiscal measures to stabilize the economy and to mobilize domestic resources.

Developed countries of the OECD collect a much higher percentage of GDP in the form of tax revenue than developing countries do. According to a 2000 IMF study, in the period 1995 - 1997, developing countries collected 18.2% of GDP in tax revenues, white OECD countries collected more than double this share, 37.9%. Developed countries may have higher demand for public expenditures and also greater capacity to generate tax revenue, and thus the causality likely runs in large part from greater development to higher tax levels. But to the degree that government resources are spent wisely, such as on human capital and needed infrastructure investments, some of the causality may run the other way as well.

Typically, "direct taxes" - those levied on private individuals, corporations, and property - make up 20% to 40% of total tax revenue for most LDCs. "Indirect taxes", such as import and export duties and excise taxes (purchase, sales, and turnover taxes), constitute the primary source of fiscal revenue for LDCs.

Developed OECD countries generally rely more strongly on direct taxes, but this pattern is much less pronounced in Europe, where reliance on indirect taxes is almost as great as on direct taxes. It is not clear whether direct or indirect taxation is better for economic development because their impacts on critically important human capital accumulation is so complex. Avoiding extreme over reliance on any one form of taxation is a reasonable approach given the current state of knowledge.

The tax systems (direct and indirect taxes combined) of many developing countries are far from progressive. In some, such as Mexico, they can be highly regressive (meaning that lower-income groups pay a higher proportion of their income in taxes than higher-income groups).

Taxation in developing countries has traditionally had two purposes. First, tax concessions and similar fiscal incentives have been thought of as a means of stimulating private enterprise. Such concessions and incentives have typically been offered to foreign private investors to induce them to locate their enterprises in the less developed country. Such tax incentives may indeed increase the inflow of private foreign resources, the overall benefits of such special treatment of foreign firms are by no means self-evident.

The second purpose of taxation, the mobilization of resources to finance public expenditures, is by far the more important. Whatever the prevailing political or economic ideology of the less developed country, its economic and social progress depends largely on its government's ability to generate sufficient revenues to finance an expanding program of essential, non-revenue-yielding public services - health, education, transport, legal and other institutions, poverty alleviation, and other components of the economic and social infrastructure.

Many LDCs face problems of large fiscal deficits - public expenditures greatly in excess of public revenues - resulting from a combination of ambitious development programs and unexpected negative external shocks. With rising debt burdens, falling commodity prices, growing trade imbalances, and declining foreign private and public investment inflows, developing-world governments had little choice but to undergo severe fiscal retrenchment. This meant cutting government expenditures (mostly on social services) and raising revenues through increased or more efficient tax collections.

In general, the taxation potential of a country depends on five factors:

(i) The level of per capita real income.

(ii) The degree of inequality in the distribution of that income.

(iii) The industrial structure of the economy and the importance of different types of economic activity (e.g., the importance of foreign trade, the significance of the modern sector, the extent of foreign participation in private enterprises, the degree to which the agricultural sector is commercialized as opposed to subsistence-oriented).

(iv) The social, political, and institutional setting and the relative power of different groups (e.g., landlords as opposed to manufacturers, trade unions, village or district community organizations).

(v) The administrative competence, honesty, and integrity of the tax-gathering branches of government.