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Fiscal states in developing economies: Why do they matter and where do they come from?

Modern states are complex organizations which perform a broad range of functions. They have an important role in economic and human development. The consensus from recent research suggests that effective states provide crucial public goods and services, such as universal education, public health systems, and an effective administration of justice.

But how do we finance state activities? Understanding this requires a study of the process of transformation of public finance institutions. This is a fundamental part of how effective states are created.

In this blog, we explain why fiscal states are important for development and offer four key lessons for those concerned with how developing economies can build effective fiscal states, building on insights from UNU-WIDER’s fiscal states project. Understanding how states finance their activities is not only an academic question, but also relevant to policy.

Countries’ ability to generate resources for development spending is explicitly recognised in Sustainable Development Goal 17 (SDG 17) in Target 17.1, ‘strengthening domestic resource mobilisation’. The achievement of SDG 17 will require genuine commitment from national elites, as well as significant stepping up of governments’ organizational efforts and, above all, increased financial resources. Traditionally, this is where development cooperation can intervene and provide a boost to the SDGs. But these are not normal times for development cooperation. Foreign aid has been flat over the last few years, with no increase in sight.

Fiscal states, why do they matter?

To illustrate the relevance of the fiscal question, consider taxation. It is central to the way that state activities are financed (although not the only source) and hence important to development spending. Using Total Revenues/GDP, Figures 1 and 2 illustrate the differences among groups of countries.

Figure 1

One can see two basic facts. First, high-income countries collect more than double the share of total revenues than low-income countries do, and almost double the share of lower-middle income countries too. Second, sub-Saharan Africa, where a significant part of those in poverty live, collects half the share of taxes that OECD countries do. But, sub-Saharan Africa does well considering its level of economic development. It has the same share of revenues as richer South Asia and is just a few points below the much richer Latin America.

Figure 2

What is the challenge then? This gap in tax performance is stable over time, i.e., it is persistent (and this does not change when looking at a longer time window extending to the two decades before 2000). This suggests that one should look at the deeper determinants that keep this gap in fiscal development unchanged over time, rather than focusing exclusively on the technical solutions of revenue administration.

So, what explains this gap? Our project on fiscal states looks at a number of aspects, and asks whether it is (only) the organizational performance of national revenue administrations or also the economic, political, and historical conditions that help to consolidate taxation.

The first lesson, Rome wasn’t built in a day

Based on the experience of the West, the construction of fiscal states takes time and is inextricably linked to historical processes of state-building. Therefore, donors have to stay the course in facilitating fiscal capacity in Africa and should not expect short-term solutions or quick fixes.

Developing fiscal states is a long-term process. Countries do not go straight from old to new forms of public finance. There are intermediate steps to becoming a modern fiscal state. Developing broad-based taxation is a sign of fiscal modernization of the highest form. At the same time, states in the developing world can finance their activities through non-tax revenues (for example, aid and development assistance or natural resource revenues), and by borrowing from private and international financial institutions. Policymakers should be mindful that financing state activities requires both developing modern taxation and managing other sources of public finance.

Second, history matters

If, and how fast, a developing economy can successfully develop effective taxation and tax systems depends on specific historical conditions, which cast a long shadow and shape today’s possibilities. For example, pre-colonial institutions can still affect tax compliance in sub-Saharan Africa, as a case study on Uganda shows. An understanding of how such mechanisms work explains why tax reforms work better in some contexts, but not others.

Third, politics matters

Developing fiscal capacity is not only a technocratic exercise. We often read of technical solutions to more efficient tax administration, including, for example, new IT solutions to tax collection and administration. This is important, but it is even more important to understand the politics which builds the fiscal contract between a state and its citizens.

The process of long-run development of fiscal states hinges on developing specific types of political institutions. Developing effective and accountable political institutions is key to the emergence of fiscal states. Donors need to support the augmentation of state capacity in Africa, as well as of horizontal and vertical accountability.

This implies that there are significant interlinkages between SDG 17 and SDG 16. The goal of promoting inclusive and accountable institutions works in synergy with that of generating the national resources to finance development goals.

Fourth, do not look at fiscal capacity in isolation

Developing fiscal capacity hinges on simultaneous institutional reforms in other areas. This is clearly demonstrated in a recent WIDER study of the Chilean and Argentine cases. The paper shows that information capacity is an important area of state capacity. It demonstrates that complementarities can be exploited. Developing legal institutions that expand protection property rights may also facilitate the emergence of tax systems in sub-Saharan Africa, by expanding the tax base.  The final lesson for developing fiscal states is, therefore, to invest in the many other dimensions of state capacity that support tax system development.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.