Research Brief
Financing Growth in Low-income Countries

It is a widely accept projection that many low income countries (LICs) will remain low income for some time to come. Consequently, when assessing the policy options available to LICs it is important to take a long-term view. In the WIDER Working Paper ‘Aid, Fiscal Policy, Climate Change, and Growth’ David Bevan sets out to highlight some important considerations that should help structure the answer to a crucial question: how can fiscal policies be designed in the face of future uncertainty over climate change, structural change, and the evolution of aid flows?

Considerations for the future

In the first half of his paper, summarised here, Bevan outlines a number of the factors that limit growth in LICs. In this half we move on to discover what he sees as some of the considerations that both domestic governments and donors should take into account going forward. In particular he looks at the various sources of financing that are available to LICs.

1. Aid

One such source of financing is aid. Bevan suggests that the prospects for aggregate aid flows going forward may be bleak. The financial crisis has led to many developed countries needing to adjust their fiscal outlays, and as such the availability of aid may diminish in the future. However Bevan suggests that aid flows to individual LICs may not suffer the same fate. If, as seems likely, some LICs succeed in exiting from this status in the medium term a smaller pool of aid may simply be distributed to fewer countries, so aid may continue to be an important potential source of financing for the remaining LICs.

2. Taxation

Another source of revenue for LICs is taxation. However it is often difficult to raise taxes in LICs due to a large informal sector, weak and corrupt tax administrations and habits of non-compliance. One obvious consequence of this is that governments tend to be smaller relative to GDP in poorer countries than in richer ones. Another potential consequence Bevan considers is whether this difference is purely due to tax capacity, or whether revenue could be sustainably increased through a greater tax effort. Bevan points out that it appears that tax effort does not dramatically differ between low and high income countries, and that consequently the lower tax/GDP ratio in LICs is primarily due to lower capacity. Bevan suggests that while there may be some scope for LICs to raise their tax revenue, the fact that the low rates are mostly due to a lower tax capacity means that a dramatic increase in revenue from taxation is unlikely to be achievable over a reasonable horizon.

3. Borrowing

Borrowing, from both domestic and international sources, is another form of financing that LICs could pursue. The IMF has suggested that a safe upper bound for the domestic debt/GDP ratio might be 15 per cent. A country with such a ratio, which it intended not to increase, could afford a domestic deficit of around 2.5 per cent if it achieved real growth of 7 per cent and an inflation rate of 5 per cent. Such figures are not unreasonable and consequently domestic borrowing could be a material source of finance for LICs. However Bevan does point to a concern that domestic borrowing may drive up interest rates and crowd out private investment. He suggests that while there is little empirical work on this issue, there is a need for caution.

As LICs have been relieved of some of their previous debt obligations and improved their macroeconomic performance non-concessional external borrowing has increasingly become a realistic potential source of finance. LIC access to such borrowing has also been improved by the traditional donors relaxing their rules about mixed financing and by the emergence of non-traditional partners. However, aside from avoiding taking on too much debt, there are two separate issues for LICs to consider when thinking about taking on external debt. First, LICs may pay a higher rate of interest than is justified by their objective circumstances due to an inability to guarantee the continuation of stable conditions. Second, 100 per cent debt financing of uncertain investments in inherently undesirable as failed investments will lead to heavy losses. Bevan concludes that these considerations, combined with the inherent uncertainty of the future financing climate, make this route of financing one to be treated with extreme caution.

4. Fiscal targets

Having looked at various potential forms of revenue for LICs Bevan poses the question of what the fiscal targets should be for LICs. The IMF suggests a target upper bound for the  debt/GDP ratio of 60 per cent for advanced economies, and 40 per cent for emerging economies. However, Bevan notes, LICs are typically in receipt of at least some concessional loans with very low interest rates and also differ enormously from one another in regard to past performance. Consequently targets that apply to all LICs are unlikely to be effective.

Some LICs have instituted fiscal rules. As an illustration, Bevan points to the example of the fiscal rules the IMF informally suggested Tanzania might consider adopting. These included a limit on the debt ratio of 40 per cent, and targets for net-domestic financing to be less than 2.5 per cent of GDP, non-concessional external borrowing to be less than 2.5 per cent of GDP, and the change in the ratio of government spending to GDP to be less than 3 per cent per annum. However Bevan argues that setting such rules may be inherently problematic. Fiscal policy has to be able to react to contingencies, simple rules may not be able to deal with contingencies very well, and flexible rules quickly become too complex to be operational. Furthermore if there is a political commitment towards fiscal responsibility then rules are probably unnecessary, and if there is not that commitment rules are unlikely to be successful. Bevan suggests that adopting an approach based on fiscal indicators and targets would allow more flexibility and provide the opportunity to take into account more criteria than would be possible under any workable system of rules.

Bevan finishes by pointing out that LICs face high volatility in the short term and large challenges in the long term. Consequently deciding on the correct policy options is difficult, as future scenarios are difficult to project. Bevan suggests that some of the issues LICs face will be country-specific, but that many will be systematic. Consequently overcoming these problems requires the involvement of both domestic governments and the wider economic community, including international finance institutions, donors, and academics.

This report by James Stewart summarizes WIDER Working Paper no. 2012/77 'Aid, Fiscal Policy, Climate Change, and Growth’ by David Bevan.