IV Fiscal Policy Issues in PRGF-Supported Programs
Author: Mr. Jan Kees Martijn, Gabriel Di Bella1, Mr. Shamsuddin Tareq, Mr. Benedict J. Clements, and Mr. Abebe Aemro Selassie
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
OP; debt; deficit; The PRGF; deficit target; debt data; deficit-growth nexus; NPV basis; debt sustainability problem; Debt sustainability; Value-added tax
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Abstract

This section assesses whether program design in the fiscal area is consistent with the best practices suggested in the literature. It begins with a discussion of the links between fiscal policy and growth, including the channels through which fiscal policy affects economic activity.

This section assesses whether program design in the fiscal area is consistent with the best practices suggested in the literature. It begins with a discussion of the links between fiscal policy and growth, including the channels through which fiscal policy affects economic activity.

Fiscal Stance and Economic Growth

The links between budget deficits and growth go beyond the traditional macroeconomic channels in low-income countries. A number of studies indicate that low levels of the budget deficit and public debt can promote growth.1 However, the precise channels through which deficits affect growth in low-income countries have received little attention. One study that has specifically examined this topic indicates that budget deficits have only a small effect on growth via the crowding out of investment (Baldacci, Hillman, and Kojo, 2004). The effect of fiscal consolidation on growth through its salutary effects on inflation is also modest. Baldacci, Hillman, and Kojo’s study suggests that other factors are at play, including the effect of reductions in expenditure on total factor productivity in countries with poor governance. In light of these findings, this section considers factors that need to be considered in choosing the optimal path for the fiscal balance over the short to medium term in the mature stabilizer sample. A closely related issue is the appropriate measure of the fiscal stance in low-income countries where most of the financing is on concessional terms; this is addressed in Box 4.1 and Appendix III.

The implication of the fiscal stance for debt sustainability is of first-order importance in assessing the optimal path of the fiscal balance. Without sustainability, debt will continue rising to high levels, hindering growth. Macroeconomic imbalances are also likely to reemerge, with further adverse effects on development.

Given the importance of sustainability, the IMF has recently made efforts to strengthen the framework for assessing debt sustainability. In low-income countries, this has entailed the forward-looking analysis of the evolution of the NPV of public and external debt and the establishment of indicative ceilings for the NPV of public and publicly guaranteed external debt (see IMF, 2004b, 2004e). This framework also stresses the need to take a comprehensive view of debt sustainability that examines not just the evolution of debt ratios, but also debt-service ratios and gross financing needs under a variety of alternative scenarios. It also stresses the importance of assessing whether macroeconomic assumptions underlying baseline scenarios are realistic in light of historical averages. Unfortunately, however, such detailed public sector DSAs for the sampled countries are limited, because systematic preparation of DSAs for low-income countries started only recently. Assessments of debt sustainability in most mature stabilizer countries must therefore be based on more limited data.

Available data suggest that debt sustainability remains a concern in many mature stabilizer countries.2 Of the 14 countries for which debt data are available on an NPV basis, half had NPV of debt-to-GDP ratios above 40 percent at end-2003 (excluding debt that has since been forgiven under the HIPC Initiative; see Table 4.1). Debt remains especially high in Albania, Ethiopia, Guyana, the Kyrgyz Republic, and Mongolia. Similarly, staff analysis indicates that fewer than half the mature stabilizers have been running primary balances in recent years that would be sustainable under somewhat neutral macroeconomic assumptions (for example, average real GDP growth of 3 percent, constant real exchange rate, and external borrowing with an average grant element of 40 percent; see Appendix IV), although primary balances in a majority of the countries would be sustainable under more optimistic assumptions (for example, real GDP growth of 5 percent). The IMF staff’s baseline scenarios project a gradual decline in debt ratios in several cases, but these scenarios sometimes assume real GDP growth that is significantly higher and fiscal policy that is significantly tighter than in the recent past. In some cases, debt is sustainable in the baseline scenario, but not in the event of modest shocks (see Box 4.2 for a discussion of the debt sustainability issue in Ethiopia).

Table 4.1.

NPV of Public Sector Debt for Selected Poststabilization Countries1

(In percent of GDP)

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Source: IMF staff estimates.

The NPV of public debt is defined here as the sum of the NPV of public and publicly guaranteed external debt plus the nominal value of domestic public debt. Data on domestic public debt are from a Policy Development and Review (PDR) Department database; data on external public- and publicly guaranteed debt are from the HIPC database as of June 2004. External debt data for non-HIPCs are from staff reports. Figures have been updated for countries that have completed a public sector DSA using the new low-income country template or that reached HIPC completion points after June 2004. Data are not available for Azerbaijan.

For comparison purposes, the NPV of public debt is also expressed net of HIPC debt relief for those countries that reached the completion point after the 2003 fiscal year.

A tighter fiscal stance, higher levels of concessionality in borrowing, or both are therefore required to place public debt on a sustainable path in many countries. In these cases, fiscal policy should target deficits that are sufficiently low and debt management policies should ensure that borrowing terms are sufficiently concessional to avoid debt sustainability problems in the future, including in the event of modest shocks. In many cases, this is likely to require an increase in grant resources (through direct grants, debt relief, or more highly concessional loans) to meet the twin objectives of debt sustainability and providing sufficient funding for spending related to MDGs.

Once countries achieve sustainable deficits at moderate debt levels, they may not benefit from further fiscal consolidation. A number of studies suggest that the deficit-growth nexus is nonlinear. The level at which deficit reduction no longer boosts growth, however, is subject to considerable uncertainty. One recent study (Adam and Bevan, 2005) suggests a breakpoint for the overall deficit (including grants) centered at 1½ percent of GDP, but with wide confidence intervals. Other studies conclude that reducing deficits has no growth payoff for those that have maintained deficits that average less than 2½ percent of GDP (Baldacci, Hillman, and Kojo, 2004; Gupta and others, 2005). In contrast, the average deficit level in the sample countries is about 4½ percent (see Table 2.3).

In countries with clearly sustainable fiscal positions, the productivity of additional outlays should be carefully assessed relative to the costs of financing. In countries with poor governance, the low productivity of outlays may be such that higher spending has a limited effect on growth and social indicators (see also the “Public Expenditure” subsection below). In particular, countries with limited absorptive capacity may also not be in a position to increase spending while ensuring that these outlays are productive (see Box 4.3). The scope for fiscal expansion would also need to take into account fiscal vulnerabilities in the face of exogenous shocks, including those due to the variability of aid. Furthermore, given the rigidity of spending commitments, especially for current outlays, the fiscal risks associated with increases in spending would also need to be assessed. Finally, in countries where debt burdens are more moderate, the pace at which new debt is accumulated needs to be monitored closely.

Treatment of Concessional Loans in Fiscal Accounts

The appropriate treatment of concessional loans in fiscal accounts has been a subject of lively debate in recent years. Under the accounting rules used by most developing countries, concessional loans are currently recorded in fiscal accounts as a financing item at their face value. Interest payments, at concessional rates, are recorded as expenditure.

Some observers prefer to conceive of a concessional loan as a combination of a nonconcessional loan and a grant. They argue that the grant element of a concessional loan should be treated in fiscal accounts as revenue, analogous to other grants. This would imply that the grant component of the loan is provided upfront, at the time the loan is disbursed. Consistent accounting would require that interest payments on such loans should then be recorded, not at the actual concessional rate, but rather at the higher, nonconcessional rate on the nongrant component of the loan.

These two approaches have different effects on the measured deficit. Under the standard approach, a concessional loan lowers the deficit over the entire lifespan of the loan (relative to a nonconcessional loan) through lower interest payments. In contrast, recording the grant element up front as revenue would lower the deficit immediately (relative to the standard approach). However, subsequent deficits would be larger, reflecting higher interest rates.

The choice between these two approaches would not affect how much spending is sustainable. Under the standard approach, the deficit path that stabilizes the NPV of debt could be identified conditionally on certain financing terms and other macroeconomic assumptions. Under the alternative approach, the measured deficit in the current period might be lower because of the inclusion of the grant element of loans in revenue. However, under this alternative approach, a lower deficit would also be required to stabilize the NPV of debt, because the interest rate on debt would also be higher under this approach. The implications for spending would be the same. The distinction would be that changes in the terms of financing would affect the NPV of the debt-stabilizing deficit under the standard approach, but not under the alternative approach.

The alternative approach is, however, administratively demanding. Given these complexities, it is appropriate to continue the current practice of recording savings from concessional interest rates at the time interest is paid, rather than at the time the loan is contracted. However, deficit targets measured under the standard approach should be evaluated periodically and appropriately adjusted when the terms of financing change.

With inflation broadly under control, fiscal consolidation is not needed to reduce inflationary pressures. This is a result of the limited impact of changes in the fiscal stance on inflation, as well as the uncertain impact of inflation on growth (see Section II). In the same vein, considerations regarding the possible crowding out of the private sector through public sector deficits may also need to play but a small part in determining the appropriate fiscal stance, given the dearth of evidence that deficits have had a large impact on private investment.

At times, PRGF-supported programs have sought to accommodate higher externally financed spending without due regard to debt sustainability considerations. Programs have targeted increases in expenditure in line with higher grants and external financing. Higher budget deficits have also been accommodated in some instances (Section II). At the same time, programs have attempted to promote debt sustainability by limiting nonconcessional external borrowing and domestic financing, even when domestic debt has been at very low levels. However, this combination of policies has not always been sufficient to ensure debt sustainability, as noted above. A heightened focus on debt sustainability (both external and public sector) and the need for more grant financing is thus warranted and should be facilitated by the new DSA framework.

Public Expenditure

In most countries, the government has a central role in providing infrastructure, education, and health services. Thus, the quantity and quality of these services will be critical not only for achieving higher growth, but also for reaching the MDGs. The goals of higher growth and meeting the MDGs are interrelated, because human capital can be a powerful engine of economic growth, including in low-income countries, and growth is vital for poverty reduction.3

Public Debt Sustainability: The Case of Ethiopia

IMF staff recently compiled a detailed public and external debt sustainability analysis (DSA) for Ethiopia (IMF, 2004b) using the new DSA templates for low-income countries. Ethiopia thus provides a useful case study for whether program design in such countries is appropriately geared toward achieving debt sustainability.

In the staff’s baseline scenario, public sector debt declines gradually. The NPV of public sector debt declines from 55 percent of GDP in 2003 to 52 percent of GDP by 2008 and then to 35 percent of GDP by 2022. Gross financing needs and debt-to-revenue ratios similarly decline.

However, this scenario is based on projected primary deficits and growth rates that are significantly better than historical averages. In the baseline, the primary deficit will be limited to 3 percent of GDP over 2005–10, compared with an average over the past 10 years of 6 percent of GDP, while real GDP will grow at 5¼ percent, well above the 3¼ percent average over the past 10 years.

Under less optimistic assumptions, the NPV of public sector debt will continue to rise. Although the past weak fiscal performance was due in part to the conflict with Eritrea, there is no guarantee that internal or external shocks will not reoccur. In the event that the real average growth rate in the baseline scenario is reduced slightly, to 4¼ percent of GDP, the DSA projects that the NPV of public sector debt would continue rising slowly, to 59 percent of GDP by 2022. If the primary deficit and real GDP growth remain at their historical averages, the DSA projects that the NPV of public sector debt will rise more rapidly, reaching 80 percent of GDP by 2022.

Nonetheless, ratios of debt service to revenue are projected to remain moderate even in less optimistic scenarios, presumably as a result of the long maturity structure of Ethiopia’s concessional debt. In the baseline scenario, the ratio of debt service to revenue is expected to remain at about the 2004 level of 6 percent. Under the scenario in which the primary deficit and real GDP growth are at their historical averages, the ratio of debt service to revenue rises continuously but still reaches only 10 percent by 2022. This indicates that, as long as Ethiopia finances its deficit on very concessional terms, near-term debt-service problems are unlikely, although debt service may still become problematic in the long run (20+ years) unless there are significant improvements in growth and fiscal performance.

Such results highlight the critical importance of obtaining financing on sufficiently concessional terms. Given past experience, there is a distinct possibility that such key variables as the primary deficit and real GDP growth will be less favorable than in the baseline scenario, which could result in rising NPV of debt ratios. If the additional financing for deficits is obtained on less concessional terms and with short maturities, debt-service ratios may also rise quickly. These results underscore the need to ensure that minimum levels of concessionality are sufficiently high and deficits sufficiently low so as to make debt sustainability problems unlikely, even in less favorable circumstances.

The average ratio of government spending to GDP in the mature stabilizers is about 26 percent of GDP (the median is 23 percent of GDP), which is relatively low compared to other low- and middle-income countries. During 1999–2003, this ratio was about 29 percent for all low-income countries and 34 percent for middle-income countries. In countries that are members of the Organization for Economic Cooperation and Development, the ratio was about 42 percent. There is also a wide variation among these mature stabilizer countries, with the ratio varying between 14 and 45 percent. The low ratio in most of these countries and the apparent positive relationship between per capita income and government spending suggests that as these countries grow, the share of government spending in GDP is also likely to increase.

Higher spending in sectors related to the MDGs is also expected to raise the ratio of government spending to GDP. Rough estimates of the size of HIV/AIDS disbursements in selected African countries in 2005 reveal that total potential funding could be in excess of 3 percent of GDP in Uganda, about 2 percent in Ethiopia, and more than 1 percent in Mozambique and Tanzania.4 However, supply bottlenecks (for example, availability of teachers and health sector personnel) will need to be addressed to facilitate the absorption of this external support (see Box 4.2). Other considerations include the sustainability and reliability of aid flows (IMF, 2005c) and the need to avoid excessive levels of debt (see “Fiscal Stance and Economic Growth” in this section). Against this background, the research on the impact of government spending and the composition of government outlays is reviewed here, along with an assessment of lessons for program design.5

Absorptive Capacity Constraints and Policies to Ameliorate Them

Absorptive capacity is defined as the amount of spending that can be effectively undertaken by a developing country according to macroeconomic or microeconomic constraints. Absorptive capacity limits are reflected in decreasing returns as spending increases. Macroeconomic constraints are conditions in the recipient country that limit aggregate spending, and microeconomic constraints are specific limitations that can significantly reduce the productivity of spending. The two types of constraints are linked. For example, if aid inflows elicit a strong enough supply response as a result of microeconomic factors, the macroeconomic constraints would be correspondingly reduced. This box focuses on issues related to microeconomic capacity constraints.1

At present, the mature stabilizers sample is underexecuting their capital budgets.2 In this context, scaling up aid and budgeted expenditure could have little effect on capital spending that is executed unless matched by efforts to tackle absorptive capacity constraints.

Absorptive capacity constraints manifest themselves in a number of ways. These include (1) weaknesses in public expenditure management (PEM) systems and low quality of governance;3 (2) weaknesses in the selection of donor-financed projects resulting in low-productivity projects;4 (3) weak incentives to adopt good policies and raise the domestic revenue effort to supplement foreign aid;5 (4) limited skilled labor and administrative capacity at the sectoral level;6 (5) high compliance costs of donor conditionality that limit the ability to execute projects;7 and (6) reliance on project rather than budget support.8

Several actions can be taken by both recipient countries and donors to improve absorptive capacity. For recipient countries, the actions are (1) strengthening PEM systems and the quality of governance; (2) improving project selection; (3) reallocating public sector employment to address bottlenecks and improve administrative capacity; and (4) increasing the use of the private sector for service delivery. For donors, the actions include working more closely with recipient countries to integrate donor projects into country poverty reduction strategies, increasing the share of aid as budget support, and improving donor harmonization.

Additional analytical work on absorptive capacity at the country level is also needed. There has been only limited analytical work quantifying absorptive capacity constraints. The additional work could analyze the impact of absorptive capacity constraints on measures of execution and effectiveness of spending at the country level, as well as providing cost estimates of various options to relieve constraints on institutional and human capital and physical infrastructure. Results of these studies could then be incorporated into the countries’ PRSPs and provide vital input into medium-term expenditure frameworks.

1 For a discussion of macroeconomic absorptive capacity constraints, see IMF (2005c).2 See Section II.3 In the 2002 HIPC Initiative tracking assessment, about 90 percent of the countries were found to have inactive or ineffective internal audits. See IMF (2002) for details.4 See Hanson and others (2003) and World Bank (2004b).5 This manifestation was documented in Gupta and others (2004). However, this effect was not clearly evident in the mature stabilizer countries in the 1990s: the change in a country’s official current transfers was uncorrelated with the change in tax revenue over this period.6 See de Renzio (2005) and World Bank (2003, 2004a).7 See Radelet and Clemens (2003), Knack and Rahman (2004), and de Renzio (2005).8 See World Bank (2004b).

The effect of government spending on growth depends on the macroeconomic context. If macroeconomic stability is lacking, even productive government spending can have an adverse net effect on growth because of its macroeconomic consequences. For the sampled countries, additional spending may be accommodated in some cases without endangering macroeconomic stability, external viability, or public debt sustainability.

Public investment can potentially raise economic growth, although empirical evidence on the impact of public investment on growth remains inconclusive. Data reported in Briceño-Garmendia, Estache, and Shafik (2004) suggest that, of 102 studies that estimate the impact of infrastructure investment on productivity or growth, 53 percent show a significant positive effect, 42 percent show no significant effect, and 5 percent show a significant negative effect.6 Still, in a recent survey, Romp and de Haan (2005) suggest that there is more current consensus that public capital furthers economic growth, but the impact is substantially less than what was found in earlier studies, such as that of Aschauer (1989).7 Recent econometric work suggests that public investment can raise growth in low-income countries and is most productive when governance is good (Tanzi and Davoodi, 2002; Gupta and others, 2005). In this context, more research will also be needed on the channels by which capital expenditure affects growth and how changes in the composition of government spending, including a shift toward capital expenditure, can support growth.

Higher public spending on health and education (both current and capital) can build human capital, but with varying degrees of effectiveness.8 For example, Baldacci and others (2004) find that an increase in education spending of 1 percent of GDP, holding other factors constant, could increase the net primary enrollment rate by 8 percentage points over a 10-year period. A similar increase in health spending would reduce under-five child mortality by 8 percent over 10 years. Several studies also find that public health care spending may have especially strong effects on the health status of the poor (Gupta, Verhoeven, and Tiongson, 2003; Koenig, Bishai, and Ali Khan, 2001).

However, the composition and efficiency of this social spending are particularly critical. Rates of return for primary and secondary education, for example, exceed those for tertiary education (Psacharopoulos and Patrinos, 2002). Similarly, public health spending that does not substitute for private sector outlays—such as preventive health outlays for immunization that have significant externalities—are likely to have the highest social returns (Hammer, 1993).9 Primary education and health care expenditures are also more likely to benefit the poor more than other types of spending.10 At present, however, a large share of spending is allocated to activities that benefit higher-income groups, rather than the poor (Davoodi, Tiongson, and Sawitree, 2003). The mix of spending inputs is also inappropriate in many countries, where a large share of budgetary resources is often used for wages, leaving inadequate funds for nonwage inputs with high productivity, such as medicines and textbooks.11

Recent research has emphasized the role of good governance in strengthening the link between social spending and social outcomes.12 Where institutions are weak, higher spending will have at best a diminished effect on social indicators (Baldacci and others, 2004). In cases where governance is weak, governments are also likely to allocate fewer resources to the social sectors (Mauro, 1998).

The appropriate mix of spending to promote growth and poverty reduction will vary from country to country. Existing research does not provide clear guidance on whether a given country should, at the margin, focus increased spending on health, education, or infrastructure. As such, a country-by-country approach will be needed.13

In sum, the literature suggests that countries should focus not only on increasing the level of spending, but also improving the efficiency and targeting of these outlays. Two-thirds of PRGF-supported programs incorporate steps to improve the efficiency of such outlays (Gupta and others, 2002). At the same time, given the large degree of inefficiency in spending, there may be scope for further attention to these issues. The design of reform policies in this area generally falls in the domain of other development partners. To raise the profile of these issues, countries could be encouraged to provide more details on specific social sector reforms in their PRSPs or other country-owned documents.

Programs should continue to emphasize a strengthening of Public Expenditure Management (PEM) systems to improve governance and the effectiveness of spending. Improvements in PEM systems hold promise as a tangible method to strengthen governance. The average PRGF-supported program contains four or five measures to improve PEM systems (Gupta and others, 2002). Given the weaknesses in PEM systems that still prevail in a number of the mature stabilizers, continued integration of PEM reforms into programs remains appropriate.

Tax Policy

This section discusses the appropriate level and structure of tax revenues and the main tax policy issues ahead.

Level and Structure of Taxation

The literature provides little practical guidance on the optimal overall level of taxation. In principle, taxation should be taken to the point at which the marginal social cost of raising an additional $1 equals the marginal social value of the additional expenditure or debt reduction that it finances. In practice, however, the marginal deadweight loss from a tax increase—a key element in this calculation—is subject to considerable empirical uncertainty, and the other elements depend on equity judgments upon which reasonable people may differ. A distinct empirical strand in the literature identifies strong correlations between the overall level of taxation and the level of income per capita, openness, and the importance of the agricultural sector, but these correlations provide little firm guidance for policy, because describing what countries do in general cannot identify what any country in particular should do. For developed countries, however, the evidence suggests that increasing taxes to finance unproductive expenditure adversely affects growth, and higher taxes used for productive expenditure have a positive, albeit mild, effect.14 The question has received less attention for developing countries, but similar findings have started to emerge.15

The tax ratio (tax revenue as a share of GDP) varies widely across the mature stabilizer sample (from 7–10 percent in Bangladesh and Rwanda to 30 percent in Guyana and Mongolia), but has generally increased over the past decade (Table 4.2). On average, it increased from 13.1 percent to 14.9 percent of GDP during the 1990s, and in only two countries—Guyana (where it was initially very high, at 30 percent), and Tanzania—did it fall by more than 1 percentage point. This is a somewhat revenue performance than for the broader set of low-income countries, for which the average rose by only ½ percentage point, to about 15 percent.16 This result is expected because the sample is a subset that has succeeded in addressing fiscal shortfalls. But the tax ratios they have achieved are not high relative to the wider comparator set, so it is unlikely that many of them have overshot their appropriate levels.

Table 4.2.

Evolution of the Revenue Structure of Poststabilization Countries in the 1990s

(In percent of GDP)

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Sources: IMF, World Economic Outlook, Statistical Annexes (various issues); IMF staff calculations.

VAT includes revenues collected by customs and inland revenue departments. Totals for direct and indirect taxes may not add because of unavailability of data for the subcategories.

Average of two years for all countries and 1999 for Guyana.

Depending on data availability, the average represents two consecutive years between 1990 and 1994.

Experience points more clearly to minimum than to maximum levels of taxation, with a ratio of at least 15 percent as a reasonable target for most low-income countries.17 Few countries have sustained minimally acceptable living standards at tax ratios below 10 percent.18 At a tax ratio of about 15 percent, most low- to lower-middle-income countries find that increasing revenue requires an expansion of the tax base that is both politically and technically difficult. Achieving a ratio of this order is a reasonable medium-term target for many of these countries. A ratio closer to 20 percent would provide more room for productive expenditures—diminishing returns do not seem to set in quickly—and there is no evidence that it would be intrinsically harmful to growth. However, some countries may reasonably prefer to set somewhat lower tax ratios than this in an attempt to spur economic activity, and the implication is certainly not that all tax rates should be in the 15–20 percent range. A relatively low corporate tax rate, for instance (combined with an appropriate definition of the base) may provide a useful encouragement to private investment.

The composition of tax revenue is also an important concern in policy design. In principle, each tax instrument—the rate of value-added tax (VAT), the extent of investment allowances, and so on—should be taken to the point at which the social cost of raising an additional $1 is the same for all: otherwise, the same revenue could be raised at lower total social cost. Explicit comparisons of this sort can rarely be undertaken, but two important dimensions of choice are of particular interest. The first is the balance between taxes on consumption—including both broad-based commodity taxes (notably the VAT) and excises—and taxes on labor and capital income. At least for developed countries, there is evidence that countries that rely more on consumption taxes tend to save more and grow faster.19 Against this, personal income taxes provide a better-targeted way of structuring an equitable tax system, although it may well be that spending measures provide an even more effective way of helping the least advantaged. The second is the extent of reliance on customs revenues relative to other sources, there being in principle clear gains to be made in moving from tariffs toward domestic consumption taxes.20

The sampled countries have come to rely increasingly on indirect taxes and the VAT in particular. Twelve of the 15 introduced the VAT in the 1990s (Honduras has had one since 1976, Senegal since 1979); Rwanda and Ethiopia introduced the VAT in the early 2000s; only Guyana remains without a VAT (and plans for its adoption are under way). The VAT now accounts on average for nearly 40 percent of tax revenues in the mature stabilizer sample.

With some exceptions, these countries have also reduced their reliance on trade taxes. On average—Azerbaijan and Ethiopia are exceptions—these reductions accounted for revenues equivalent to 2.8 percent of GDP in the early 1990s but 2.3 percent at the turn of the century, a modest but worthwhile structural improvement. It is largely by introducing or improving the VAT that these countries have recovered lost trade tax revenues. In Bangladesh, for example, trade tax revenues fell by about 0.3 percent of GDP while revenue from the VAT increased by 0.7 percent. This experience runs counter to the emerging evidence that low-income countries, in general, have not succeeded in recovering lost trade tax revenues.21 The success of the countries in doing so is important, not least for the example it provides to others.

Current and Future Tax Policy Issues

The most prominent tax policy issues that need to be addressed for the mature stabilizer countries in the coming years are likely to be as follows:

  • Strengthening the VAT. This is not a matter of increasing rates of the VAT. These are not low by international standards, averaging over 17 percent and with only Honduras now having a standard rate below 15 percent (Table 4.3). Further increases would likely put significant pressure on the wider system by increasing the attractions of noncompliance. The issue is rather to expand the base of the VAT, primarily by reducing exemptions and improving compliance. Gains from this source can be seen in Table 4.3. The C-efficiency is the ratio of VAT revenues to the product of the standard VAT rate and total private consumption. If all consumption were subject to the VAT, C-efficiency would be unity.22 That is rarely the case even in developed countries, but a ratio closer to 40 than to 30 percent should be within the sights of most sampled countries. C-efficiency has increased in this sample, but there is still scope for significant improvement in some countries. In Bangladesh, for example, increasing C-efficiency to 40 percent would increase the tax ratio by nearly 1 percentage point.

  • Reducing reliance on trade tax revenues. At an average of 16 percent of total tax revenue—and about one-fourth in some—trade taxes remain an important source of revenue. Some degree of trade liberalization may be possible without reducing trade tax revenues further (for example, by eliminating exemptions or by reducing protective tariffs set above revenue-maximizing levels). Although no summary measure can fully describe potentially complex tariff systems and the range of potential reforms, it is notable that all of these countries have collected tariff rates below the 20 percent estimated to be revenue maximizing by Ebrill, Stotsky, and Gropp (1999).23 With trade tax revenues already declining in most of these countries, continued trade liberalization will intensify the need to improve domestic tax systems. This will often involve strengthening the indirect tax system, including the VAT (reducing exemptions and rate differentiation, for instance). To avoid transitional revenue losses, such measures need to be carefully sequenced with those of trade liberalization.

  • Dealing with pressures on corporate tax revenue. Several of the mature stabilizers have seen a noticeable reduction in their revenue from corporate taxation over the last decade (for example, 1 percentage point in Albania and 1½ points in Azerbaijan (Table 4.2)). Statutory rates of corporate tax have fallen considerably (Table 4.3), from 42.2 percent, on average, to 32 percent. In most of these countries,24 the loss of revenue has been smaller than the rate reduction alone would imply, suggesting that—again unlike the broader set of all low-income countries—these reductions were accompanied by either a significant supply response or some tightening of tax exemptions. Nevertheless, it seems likely that corporate tax revenues will continue to come under pressure: corporate tax rates continue to fall around the world, and the current rates in the mature stabilizer sample are high relative to, for example, some European Union (EU) accession countries. Mitigating this pressure requires avoiding excessive exemptions, such as tax holidays and direct tax breaks for exporters, that not only seem to do little to attract investment but also erode revenue both directly and by creating avoidance opportunities. The most effective way for countries to avoid giving excessive exemptions may be by entering regional agreements, not least because regional trade integration sharpens internal competition for FDI (as with Tanzania within the East African Community). Experience in the EU suggests that issues of corporate tax coordination are best addressed early in the integration process.

Table 4.3.

Selected VAT and Corporate Income Tax (CIT) Indicators1

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Sources: IMF, World Economic Outlook; Statistical Appendix (various issues); IMF, Technical Assistance Reports (various issues); KPMG Worldwide Corporate Tax Rates Survey (various issues).

Depending on data availability, the average represents two consecutive years between 1990 and 1994.

Average of two years for all countries and 1999 for Guyana.

Improving tax administration is as important as improving tax design. Strengthening audit capacity, constructing organizational structures that provide appropriate incentives for information exchange, and fair tax enforcement are all critical to the expansion of the tax base, which is key to improving revenue mobilization and reducing the distortions and inequities of their current tax systems. But the potential impact of administrative improvement alone should not be overstated, especially in the short term. The links between design and administration are also key: where compliance and governance are poor, simplicity of design is critical for good administrative performance.

1

Easterly and Rebelo (1993); Easterly, Rodríguez, and Schmidt-Hebbel (1995); Pattillo, Poirson, and Ricci (2002); Clements, Bhattacharya, and Nguyen (2004); Gupta and others (2005); and Adam and Bevan (2005).

2

Assessments of debt sustainability should take into account multiple indicators and country-specific factors such as the quality of institutions and policies.

3

For reviews of this literature, see Krueger and Lindahl (2001) and Baldacci, Hillman, and Kojo (2004).

5

The discussion focuses on public spending on infrastructure, education, and health care. For an examination of how public transfers can either retard or promote growth, see Boadway and Keen (2000).

6

In multiple-country studies, 40 percent show a positive effect, 50 percent show no significant effect, and 10 percent show a negative effect. In contrast, all 12 single-country developing country studies show a positive effect.

7

The same authors also caution that “only a few of the enormous bulk of studies on the output effects of infrastructure base their estimates on solid theoretical models,” and they suggest that more research is needed on the channels through which infrastructure has an impact on growth.

8

The results from the literature are far from uniform, however, with some studies showing only a weak or no link between spending and educational outcomes. For a review of this literature, see Baldacci and others (2004) and Kremer (2003).

9

Empirical evidence for this proposition has, however, been mixed. For example, a case study in Malaysia (World Bank, 1992) found that infant mortality was more strongly affected by increasing immunization than by increasing the number of doctors per capita. In contrast, Gupta, Verhoeven, and Tiongson (2002) find that the share of primary health spending in total health spending has an insignificant effect on aggregate outcomes.

10

However, some types of tertiary education, such as training of teachers and nurses, may have significant social returns and benefits to the poor.

11

See, for example, Kremer (2003) and Kremer, Moulin, and Namunyu (2003).

12

See also IMF (2005a).

13

For a discussion of general frameworks for assessing public expenditure, see Chu and others (1995), Pradhan (1996), and Paternostro, Rajaram, and Tiongson (2004).

14

See Kneller, Bleaney, and Gemmell (1999) and Widmalm (2001).

17

Adam and Bevan (2004) speak of a consensus that the tax ratio for poststabilization countries should be on the order of 15–20 percent.

18

Of 103 countries examined in Keen and Simone (2004), only 15 had a tax ratio below 10 (and 7 of these were oil producers).

19

Tanzi and Zee (2000) and Kneller, Bleaney, and Gemmell (1999).

20

The argument, and its limitations, is spelled out in Keen and Ligthart (2002).

22

Ebrill and others (2001) discuss the limitations of C-efficiency as a summary measure for the assessment of a VAT.

23

The collected tariff rate—the ratio of tariff revenue to import value—averages about 9 percent, with a range from 1.2 (the Kyrgyz Republic) to 18.3 percent (Benin).

24

The exceptions are Albania and the Kyrgyz Republic, where the starting point of the early 1990s reflects the early days of their transition from the strong reliance on corporate taxes under the pretransition tax regimes. Keen and Simone (2004) document a reduction in corporate tax revenues in the wider set of low-income countries, though the underlying data are poor and the role of cyclical factors remains unexplored.

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Cover Designing Monetary and Fiscal Policy in Low-Income Countries
Designing Monetary and Fiscal Policy in Low-Income Countries
Author: Mr. Jan Kees Martijn, Gabriel Di Bella, Mr. Shamsuddin Tareq, Mr. Benedict J. Clements, and Mr. Abebe Aemro Selassie
ISBN:
9781589064966
ISSN:
0251-6365
Publication Date:
19 Jul 2006
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589064966.084
Pages:
58

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