Research Brief
Taxation, Public Expenditure and Aid Effectiveness

In a recent UNU-WIDER working paper 'Fiscal composition and aid effectiveness: A political-economy model' Paul Mosley examines the claim that aid would have, in the long term, a negative impact on productivity and stability of expenditure in recipient countries, due to its tendency to undermine tax systems.

The importance of the fiscal determinants of aid effectiveness

In this paper Mosley posits that fiscal performance is a crucial factor in determining the effectiveness of development aid in the long term. He defines fiscal performance as the level of productivity of public expenditure and the willingness of governments to finance that expenditure out of these taxes, rather than out of aid. Willingness to finance expenditure out of taxation is included because the long term tax based expenditure is more stable and productive than expenditure financed from development aid, which by definition must be discontinued as if the country is to become financially self-sustainable. Logically then aid will be more effective in improving fiscal performance, if it incentives, rather than substitutes for, the creation of tax revenue.

It is always politically costly to raise tax revenue and this is particularly true for poor countries with weak states. They therefore often rely on donors to finance additional expenditure through development aid. In these countries an evolution of the tax structure requires the elites to put long term developmental interests above those of short term political survival. It is thus clear that in order to understand how aid effectiveness can be improved we need to know what determines the likelihood of the elites in a recipient country taking a long term view in their policy making. The paper puts forwards four hypotheses to this effect.

The first hypothesis suggests that a move towards inclusive allocation of fiscal resources often occurs due to elites realizing that exclusiveness has consistently failed to deliver growth or political stability. This pattern is evident in the 1990s in Ghana, Mozambique, and Rwanda, at the turn of millennium in Sierra Leone, and more recently in Bolivia, Ecuador, Argentina, and Indonesia. In all these cases regimes learned from the experience of political trauma and instability and fundamentally modified their political system and fiscal regime.

The second hypothesis is that the introduction of policies which signal equity and fair treatment emanating from the elite can help create a more durable political settlement through inclusiveness. A good example of such a move is the link made between taxes on mineral imports and payments made to pensioners and the unemployed in some Latin American countries (Argentina, Bolivia, Ecuador). This kind of policy makes taxation part of a social contract in which the public is involved, rather than a coercive and unjust process over which they have no control. Changes to the constitution which aim to deliver greater social justice and shifts towards more equitable taxation and expenditure policies can have a similar effect.

The third hypothesis deals with the relationships formed between donors and recipients of aid which can be crucial in determining the possibilities for tax diversification and therefore to determining public expenditure and aid effectiveness. Mosley states that aid can have both a positive and negative effect on long term fiscal capacity. The negative effect occurs when recipient governments use aid flows to substitute for tax effort. However if a government has a long term developmental attitude, fostered by a relationship of trust between donor and recipient, aid can be used to derive the ideas and hire the personnel necessary for a diversification of the tax base through technical assistance and institution building.

The fourth hypothesis posits that the state of a countries macro-economy influences the scope for varying tax and expenditure levels. In particular, when the fiscal balance becomes unsustainable governments are under more pressure to raise taxes.

Findings

Mosley’s argument is that the political economy elements described above determine tax structure and the ability of tax revenue to grow in countries that receive aid. In turn tax revenues play a role in determining expenditure, and these fiscal variables determine the ability of the state to deliver public services. Therefore, as stated previously, in order to be effective aid needs to incentivize rather than undermine tax effort in recipient countries.

After modeling and testing the above hypothesis Mosley reports the following key results:

• Tax structure, trust-relationships and, in particular, the provision of technical assistance all exercise a significant influence on the level of tax effort (measured as GDP/tax ratio).
• Tax effort exercises a significant influence on the ratio of expenditure to GDP.
• Within this system of relationships aid has a weakly significant impact on growth  and a stronger 'positive' direct influence on poverty measured by child mortality.
• When the model is adjusted to account for a possible time delay between aid being delivered and it having an impact the positive correlation between aid and growth although still present, loses its significance.

The paper concludes that tax effort is undoubtedly an important determinant of a country's ability to transform itself into a developmental state and therefore in determining that country's capacity for growth. Consequently if we are to understand the relative effectiveness of aid we need to look at both the linkage from tax structures to growth to aid, as well as the linkage in the reverse direction, from aid to tax structure.  The relationship between aid and tax structure can be both positive and negative. Which road is taken depends on the political economy of the recipient state, as well as the relationship between the donor and the recipient. There some evidence that aid can help to increase tax revenue by encouraging growth and stronger evidence that technical assistance in laying the groundwork for an expansion of the tax base is critical in for an expansion of tax capacity.