12 Limitations of the Role of Tax Policy in Economic Development

Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie
Published Date:
June 1987
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Parthasarathi Shome

The role of taxation and associated incentives in development is one piece of a large puzzle. Tax incentives may assume importance if tax policy is seen to play an instrumental role in development. Tax policy, in turn, may have perceptible ramifications on the savings rate and, therefore, on investment in the economy which, in the traditional literature, is the kingpin in an economy’s development. There have, however, been other “structural positions” regarding the force behind or limiting development where natural resources are not a constraint. These are (1) the inadequacy of export markets due to protectionism abroad in the case of countries with a high degree of dependence on trade; (2) “investment” {even though this is treated as current expenditure by economists) in health, education, and other social infrastructure; (3) population control in countries such as India and China, or the lack of a large population (i.e., the smallness of market size) in others; (4) the role of appropriate technology, that is, the choice of techniques; and (5) the role of agriculture (e.g., land reform, extension services, innovation) independent of the effects of savings and investment. Therefore, in our attempt to study the effects of taxation on output—growth and development—we need to go back to the drawing board to see where taxation fits into the development picture and how important it is to the development process. Since the role of taxation is inherently linked with that of savings, this chapter begins by reviewing the treatment of savings in the development literature and then contrasts and compares it with the role of other measures of development. This is not to belittle the role of fiscal policy in economic development but to gauge it more comprehensively and to better understand its possibilities and limitations.

A perusal of the postwar literature reveals that, while the proponents of savings as a vehicle of growth were in the forefront of the discussions on growth, issues such as the role of economic infrastructure and social dynamics in the development process were being raised at the same time, even though the latter became more fashionable in the 1970s. At times the traditionalist view—savings and investment—of the development literature is perceived as an alternative to the structuralist view—financial intermediation, social infrastructure, population pressure, agricultural reform and adoption of modern technology, and factor-substitution problems. At other times, their roles are cast as complementary, for example, a better financial structure or a more educated public aiding in the savings performance of the economy. Whether treated as substitutes or complements, tax policy emerges as a modus operandi for the various tenets of development. Section I discusses the different factors that have been cast as instrumental in the development process and Section II assesses the role of tax policy in affecting these factors. Section III offers some concluding remarks.

I. The Determinants of Development

The savings literature is inherently connected with issues of external economies and of surplus labor and labor productivity, problems which are related to those of sectoral factor proportions. The issue of surplus labor—removal of a laborer from a peasant economy does not diminish productivity—is usually set against the backdrop of a lack of sufficient capital for growth. The right technique of production, that is, the right combination of labor and capital, therefore, assumes importance in the debate on the determinants of development. Among the seminal works in this area are those of Lewis (1954), Eckaus (1955), and Sen (1960) for the factor-proportions problem1 and for the implication of a labor surplus on an economy’s development, and those of Rosenstein-Rodan (1943), Scitovsky (1954), and Bator (1958) for the effects of external economies and for the need for additional investment to internalize them.

Immediately, savings—and, consequently, investment—rise in significance in that savings form the scarce factor of production. Improved savings performance thus becomes the vehicle of growth since investment follows savings. Much of the related literature derives from Harrod (1939) and Domar’s (1946) early formulations of the relationship between savings and growth. The Harrod-Domar framework emphasizes the relationship between the savings rate and the growth rate of an economy by stipulating that, in an economy with v as the capital-output ratio and s as the savings rate, a unit of capital, K, produces 1/v units of output Y, of which s/v is saved, that is, the rate of growth of capital stock. This is also the rate of growth of output g, since the capital-output ratio is kept constant.2

While investment determines the rate of growth in the early literature, later literature sees the conversion of savings to investment as a possible bottleneck for development in the forms of external as well as domestic structural rigidities. For example, investment goods may have, necessarily, a foreign exchange component. In the event of foreign exchange difficulties arising from export and import inelasticities, a country may be faced with a “foreign exchange gap” even when its “savings-investment gap” is closed. External constraints in the form of foreign exchange to transform domestic savings into investment, of which imported capital goods are an integral part, are considered by Chenery and Strout (1966), Joshi (1967), Atkinson (1969), and Nelson (1970) among others. The foreign exchange constraint is also caused by the nature of the primary commodities exported—tea, coffee, cocoa, jute—usually represented by inelastic supplies so that their price responsiveness is limited and by various forms of protectionism against imports of light manufactured goods.

Domestic constraints on growth have several sources. First, as Nurkse (1953) points out, the problem in many developing countries is not a shortage of savings, but the limited size of the market leading to low investment: “Many articles that are in common use in the United States can be sold in a low-income country in quantities so limited that a machine working only a few days or weeks can produce enough for a whole year’s consumption” (p. 7). This problem of limitation is linked not only with the low standard of living in many a populous developing country but also with the low absorptive capacity of those developing countries that are sparsely populated.

Second, investment in machinery that produces consumer goods is seen as a leakage from the long-run rate of growth by Mahalanobis (1953) and other “planner” economists. In other words, varying the composition of capital stock—in its respective uses as producing consumption or investment goods—provides an extra handle to attain higher growth rates. Investment in the production of consumption goods that cannot be decreased, therefore, limits growth.

Third, the difficulties in the transfer of technology from developed to developing countries are seen to reveal the insufficiencies of savings for development. Bruton (1955), in a review of the Harrod-Domar models in the context of developing countries, writes, “In the literature on economic development… emphasis is always placed on the need for more and more capital. This is surely correct and was never a secret. It would appear, however, that, though more capital is a necessary condition for speeding up the rate of development, it is not a sufficient condition… . There is no reason at all to assume that [modern] technology … can be bodily transferred to other countries” (pp. 335-36).

Fourth, the conversion of domestic savings or potential savings to investment is seen to be arrested due to the lack of adequate financial institutions by Patrick (1966), Gurley and Shaw (1967), Goldsmith (1969), McKinnon (1973), and others. Gurley and Shaw (1967) emphasize four “technologies” for savings mobilization and allocation: self-finance, taxation, debt-asset ratio, and foreign aid. Each technology has a yield and a cost component, the net yield being its ability to raise savings and investment, the economy’s capital stock and, thus, the flow of consumption. While they treat all of the technologies as substitutes, they assert that, in each phase of development, an economy has an optimal combination of savings-investment technologies, there being no optimal combination across space and over time. Patrick (1966) emphasizes the role of financial policy in encouraging savers to shift from tangible to financial assets and also in increasing savings, investment, and production. He calls this an approach of “supply-lending finance” where financial institutions are established and instruments created even before the emergence of a perceptible demand for them in an effort to stimulate growth. Growth is thus cast as a direct result of an efficient financial system, whose success requires government participation and innovation as well as public confidence.

The literature since the 1970s focuses more on the role of government in the development of the financial sector, for example, in Tanzi (1976), Bhatt and Meerman (1978), and Von Pischke and others (1983). Tanzi (1976), for example, states, “It would certainly be desirable for the developing countries to have financial institutions that worked smoothly and efficiently to promote economic development. Unfortunately, many developing countries … do not have the benefits of such institutions… . There is then a particular and rather obvious role that the government of these countries can perform” (p. 911). Bhatt and Meerman (1978) continue in the same vein by bringing attention to the role of the central bank in the development of the financial sector. Emphasizing that the function of a sound financial structure is to improve the mobility of financial resources and that innovations in financial structure are at least as important for development as those relating to the production structure, they identify the central bank as the agency that should carry the responsibility for promoting a sound financial structure. Von Pischke and others (1983) have brought together a number of essays testifying to the importance of the role of “financial markets in rural areas, to their performance, structure, institutions, operations, costs, and the nature of their services to rural people” (p. 5). To conclude, the ramifications of having a sound financial structure as an economy progresses along its path of development have been seen to be significant since at least the 1960s.

Other scholars such as Myint (1954), Myrdal (1968), Haq (1971), and Meier (1976) differentiate between concepts of growth and development, and expenditures in areas traditionally perceived as consumption, such as health and education, are perceived as causal factors in the development process, most notably by Streeten (1967). Thus, development is perceived by them as a conglomeration of policy objectives comprising an increase in real per capita income sustained over a long time, pari passu with a minimally acceptable structure of distribution (such that no one is below a clearly defined poverty line), attained through a process that generally increases social welfare. Associated with these concerns, infrastructure in education, social services, health, and other issues under comprehensive phrases such as “minimum needs strategy” and “human resource development” are emphasized.

In this broader context of development, additional “structural” factors in the development process may be listed. First, population has been perceived as a leading determinant of development. In the postwar literature this is addressed by Clark (1953), Ohlin (1967), Walsh (1970), and Chandrasekhar (1972) and later by Hauser (1979) and Birdsall (1980). Among demographers, the accelerating rate of world population growth—especially in developing countries—is seen as the one basic impediment to a nation’s progress since population strains an economy’s resources to the hilt. Countering this proposition is the argument that population growth makes market expansions possible. Thus, population growth during the modern era has both positive and negative influences on economic development: China, the country with the largest population in the world, has modified its population policy significantly over the years, stressing, relaxing, and once again stressing population control in recent years, as reported by Coale (1981) and others. In conclusion, the pressure of population on a country’s economic performance cannot be denied. In countries with high population densities, the economic game may be reduced to one of perennially catching up with population growth.

Second, the impact of the agricultural sector on development is a much discussed topic. It cannot be adequately covered here except by noting certain benchmark trends.3 While in the 1950s some, like Viner (1953) and Lewis (1954), envisage the agricultural sector as important, most economists, including these two, also perceive it as a means for industrialization. In the 1960s, however, agriculture is assigned a direct role in development (Eicher and Witt (1964)). It begins to be realized that the squeeze on agriculture in the 1950s has had negative ramifications for domestic demand as well as for exports during the 1960s. By the late 1960s, agricultural development becomes congruous with the concept of “development from below,” and the literature of the 1970s, for example, Yudelman and others (1971), Lele (1975), Benor and Harrison (1977), Singh (1979), and Berry and Cline (1979), focuses on land reform, extension work, technological change and innovation and the like. The relevance of agricultural incomes is reflected in the concern for the agricultural and nonagricultural-industrial terms of trade, predictably resulting in inconclusive debates through the 1970s and 1980s. As in the case of rural-urban terms of trade, the debate over land reform has not yielded clear conclusions either.

In spite of the above-mentioned uncertainties, today the development of agriculture per se is understood to be a vital component in the improvement of the quality of rural life and, given that significant proportions of the population of developing countries remain rural, an independent determinant of development. Raising the rate of financial savings may often have little effect on an impermeable nonmonetized agrarian sector, and the latter’s welfare may need to be addressed directly if the goal is the development of the country as a whole.

Third, a considerable portion of the development literature, for example, Acharya (1975) and Rhee and Westphal (1977), considers the question of relative factor-substitutability in production functions—its responsiveness to price signals—as a structural problem, employing linear programming techniques in the analysis of the modern sector of developing economies. If labor and capital were easily substitutable, population would not be such a limiting factor, but empirical evidence on the factor-substitution question is certainly not conclusive. The econometric approach, usually measuring the factor-substitution elasticity between labor and capital, is often termed as casual empiricism (Bhalla (1975), White (1978)). Little (1982), in a survey of the evidence on various country experiences, points out that low-income countries use more labor-intensive techniques compared with middle-income countries and very often use machinery that is obsolete in the latter. Therefore, he concludes that, where production is for export markets where both compete, production factors are substitutable for the same commodity. But this argument seems to be valid only when confined to goods that fit the argument.

In conclusion, one might say that the extent of factor-substitution possibilities in a developing economy depends on the pattern of its production. During the 1950s and 1960s, when many of these countries achieved independence, a significant number of them opted for prestigious, capital-intensive projects in both the manufacturing and agricultural sectors. As a result, and in the absence of domestic technology, the difficulty with factor substitution was seen by many of them as structural, leading, in turn, to the belief that foreign exchange was the dominant gap in development, a consideration that we have addressed above. By the 1970s, however, the often minuscule returns from these unsuccessful programs re-educated these countries regarding shifting techniques and production structures, even if through the endurement of stresses and strains.

II. Tax Policy and the Determinants of Development

If a comprehensive concept of development includes raising the rates of saving and investment in order to increase output, raising social investment in health, education and welfare, streamlining the rate of population growth with the rate of accumulation of capital stock, and safeguarding a reasonable terms of trade for the agricultural sector such that the latter’s growth is assured, the role of tax policy is automatically extended from one of aiding the first criterion to all the others as well. Indeed, under appropriate assumptions, tax policy can theoretically be a powerful instrument in targeting all of the above factors of development. Whether such assumptions hold in many developing countries then becomes the question to ponder. Below we summarize the possibilities for and limitations of tax policy as a means of affecting the above-mentioned components of development.

Among the various means by which a developing economy may increase its investment rate is taxation. By taxation, the government reserves a portion of the national resources for itself, often for capital construction projects, or offers it to the private sector for similar purposes. The Union of Soviet Socialist Republics has used a sizable turnover tax to finance capital formation. Japan, in its early development, has used a land tax for the same reason. Several low-income and middle-income countries—especially in South Asia and Latin America—have attempted to raise domestic savings through payroll taxes or compulsory social security schemes. While these endeavors have mostly been mired by inflation in the case of Latin America, they have been significantly successful in Asia—Malaysia, the Philippines, Singapore, and Sri Lanka—where provident and pension funds seem not only to not have affected voluntary savings (Datta and Shome (1981)) but have also made available to their governments long-term investment funds for development purposes, as the accumulated funds of these institutions have become the primary source of financing of public debt (Shome (1986)). Theoretically, they can also be used to maximize an economy’s utility from consumption at an equilibrium factor proportion, that is, take an economy to its “golden path,” with appropriate financing methods (Shome and Squire (1983)).

Apart from direct quantitative controls, tax policy has been used in attempts by developing countries to close their foreign exchange gaps through import tariffs, free trade zones, income tax incentives for export diversification, such as in the case of light manufacturing goods, or contrarily, export duties in the case of traditional primary exports with low elasticities of supply. Indeed, theoretically, export subsidies and import taxes can have the same effects as those of exchange rate policies since a 10 percent ad valorem subsidy on all exports matched by a 10 percent ad valorem duty on all imports has similar economic implications as a 10 percent devaluation, with one difference: the devaluation affects all items of the balance of payments, while the tax-subsidy mix affects only the mercantile items. Arguments that have been put forward in favor of a tax-subsidy mix are its selective nature and the lower inflationary pressure it generates.

Tax policy is utilized to encourage financial intermediation through special tax treatment of both dividends, to encourage the development of the stock market, and interest, including interest from banks, governments, housing authorities, and insurance institutions, as well as from unit trusts and the like. The role of fiscal policy, in general, as a complement to the development of the financial sector has already been discussed above. Tax policy, to change factor proportions, is also used widely through incentive packages including accelerated depreciation, income tax holidays, labor-utilization relief, deductions for research and development, and so on. Almost all developing countries boast a complex system of tax incentives, the ramifications of which are often difficult to trace through the economic system. Corporate tax incentives that tend to reduce the cost of capital and subsidize capital use exist side by side with labor-utilization relief that should encourage labor intensity, the net effect of the two often being intractable. However, tax policy usually remains the main tool in a country’s cache of instruments in handling the factor-proportions problem.

Tax policy can similarly be used to affect the other factors of development. China now uses a heavy tax on married couples who have more than one child. India and several other developing countries also experimented with the same type of tax in the early 1970s by offering higher personal income tax breaks for smaller families, or by reducing the number of children for which tax credits and allowances are given. Thus, tax rates can be manipulated to make the choice between having and not having children more dependent on an opportunity cost that reflects an economic rather than a social cost.

The issue of a favorable treatment for agriculture in the literature on agricultural taxation has been much debated. Indeed, in the early literature, several economists have argued that agricultural taxation is necessary in developing countries to extract the agricultural surplus or for reasons of inter-sectoral equity. Gandhi (1966), for example, quantifies the “under-taxation” of Indian agriculture relative to other sectors. According to World Bank (1982), in the last two decades not only has the proportion of gross domestic product (GDP) accruing from the agricultural sector fallen sharply in developing countries but so have the output per worker and the differentials in outputs per worker between agricultural and nonagricultural sectors. This type of reasoning has again brought about arguments for rehabilitating the agricultural sector with the aid of tax-subsidy policies, for example, export duty removal and import duty exemptions for tractors, seeds, and fertilizers. It must be noted in this context that even the United States has long utilized direct subsidies to the farm sector for leaving land fallow or reducing the production of milk in order to assure a domestically acceptable terms of trade for this sector.

Tax and expenditure policy is, of course, the primary vehicle through which human resource development—social security, social welfare, education, nutrition—has been attempted. Many developed countries, especially those in Europe, have very high social expenditures in relation to GDP and the ratio has grown rapidly in recent years (Tanzi (1986)). Indeed, it has been argued that the huge deficits of European nations are now being caused primarily by social welfare coverage and that further taxation on this account is almost impossible (Mach (1979)). For developing countries, the use of tax policy to achieve the human welfare component of development is not yet exhausted. Countries such as Sri Lanka have demonstrated what can be achieved in terms of literacy and longevity when government fiscal policy takes these up as focal points of development, while others such as India have yet a long way to go.

Taxation has its limitations and difficulties, however. In general, the success of tax policy depends on four tenets: that everyone is covered by the tax regime, that the incidence of taxation is known, that the rate of the tax is adequate, and that behavior is affected solely by price. If the first criterion is not met, for example as is the case in most developing countries where the rural sector hardly pays any income tax, experimentation with higher marginal tax rates on families with large numbers of children could be expected to have rather limited results for the country as a whole since a high proportion of the population may be rural. If the second condition is not satisfied—tax incidence is difficult to determine with certainty—then the tax policy may yield results far removed from its objective. For example, if the corporate tax is passed on to labor, then an increase in the corporate tax rate may not reduce capital-intensity (Shome (1978)). So the question of incidence is quite important in issues of factor-substitution. Third, if the rate of tax is not high enough, its potency is reduced. For example, legislating an array of taxes with low rates may have a smaller overall impact than a single tax with a high rate where the objective is the same. Fourth, if behavior is price responsive but is also affected by other less observable and noneconomic determinants, then the use of tax policy—by affecting price—to modify behavior may be vitiated. Sending children—especially female—to school to receive primary education may not depend on whether it is free but on whether it is permitted by society.

Actual experience bears witness to all these concerns with respect to the exercise of tax policy. Taxes on the poor are limited by existing poverty. Taxes on the rich may affect savings adversely and are often difficult to institute politically. In primarily agricultural countries, tax collection is a major hurdle as farmers are difficult to tax and often, marketed surpluses may be small as a proportion of production. Similarly, the incidence of direct taxation is an issue that has remained unresolved through the decades. Finally, not much space needs to be devoted here to the issue of non-price determinants of economic behavior since these are of greater concern to sociologists and anthropologists than to economists.

The limitations of tax policy may emerge from another direction. It is argued that if marginal tax rates are prohibitive, they may have detrimental effects on the rate of growth by truncating the rates of saving, investment, and labor supply. These concerns regarding the excessive use of tax policy have recently been revived under the banner of supply-side economics, which advocates the reduction of high marginal tax rates in order to release the forces of supply of savings, investment, and labor. As the supply of factors of production is purported to increase, output increases and so does the rate of growth. However, as Tanzi (1983) points out by citing the example of the United States, even if supply did respond to tax changes in the long run, tax policy by itself may not be able to yield supply-side effects in the face of noncomplementary changes in other policies, such as those relating to the monetary and financial sector. Also, whether or not tax policy affects marginal tax rates may be crucial to the success of tax policy from the supply-side point of view. Thus, while economists have to, and indeed, do assign a major role to tax policy in tackling development and growth, and sometimes successfully, it must be done with perspicacity.

III. Concluding Remarks

The above review, albeit selective, has attempted to put into perspective the role of the orthodox savings-investment strategy in the development process as a prior step to a study of the importance of fiscal policy since, traditionally, fiscal policy has been treated as an integral part of a composite orthodox strategy for development. In that endeavor, the chapter has reviewed some of the seminal works in the growth literature based on the effects of savings on growth, and forming the major building blocks in their application to the early development literature on surplus-labor economies. It then touched on the ensuing literature on the limitations of this strategy, such as the foreign exchange gap, the lack of an optimal financial structure as well as of economic and social infrastructure, the population explosion, the role of the agricultural as opposed to the industrial sector, and the difficulties with neoclassical assumptions of factor-substitution. Indeed, it is found that the literature has often treated financial development, infrastructure, and agricultural development as alternative “technologies” to development. Some economists have also emphasized the complementary roles that these elements can and need to play during the development process.

What emerges from this review for our ultimate purpose of the study of the effectiveness of tax policy is the following. Tax policy and, generally, fiscal policy form one component of the savings-investment strategy of development. There are ample views, however, in the literature on which route to take for development, the savings-investment strategy being only one among several or, at most forming a complement with other factors. The role of tax and fiscal policy, therefore, should be seen in this perspective as an atomistic part of a much larger whole. Before placing excessive reliance on tax and fiscal policy, therefore, it is important to bear in mind the relative position of tax and fiscal policy as a determinant of development. This is not to belittle the role of fiscal policy, however. Once we have a clearer impression of its limitations, we may be better able to form objectives and pursue goals to be addressed by tax and fiscal policy.


These issues are inextricably linked with the “structural” feasibility or infeasibilily of capital-labor substitutability—as posed by more recent literature—and are, therefore, addressed in this context, below.

See Sen (1970, pp. 9-14).

The authors cited here certainiy do not comprise an exhaustive list of those who have addressed these issues.

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