Reflections on Changing Development Fiscal Strategies over Time
Views on the government’s role in economic development have changed dramatically over the past 60 years. In the late 1940s and 1950s the United Nations had alerted the world to the wide differences that existed in per capita incomes between countries in the “developed” world and countries in the “developing”, or as it was then called the “under-developed” world. Foreign aid and technical assistance came into being, to assist developing countries, notably in fiscal matters.
Tax experts were sent in large numbers from developed to developing countries to advise and teach them how to reform their tax systems and how to collect more tax revenues. The experts usually tried to create tax systems that were similar to those in the countries where they came from. At that time, much of the attention was directed to the personal income tax because it was then considered to be the “fairest tax”. The hope was that income taxes would help raise, in a progressive and equitable manner, the tax levels of developing countries, providing policy makers with more resources.
This was also the time when “capital accumulation” (i.e. net investment) was considered the main factor in promoting economic growth. It was the time when “Harrod and Domar’s theories of economic growth” were widely accepted.
The capital accumulation could be public and private. Private investment could be stimulated by the use of tax incentives for investors while public investment required government spending and, consequently, higher tax revenue.
Developing countries were advised to: (a) increase their tax levels; (b) provide tax incentives to private investors; (c) keep current public spending low, because it was considered unproductive; and (d) use the (current) surpluses generated in public accounts to increase public investment in physical infrastructure. This was seen as a sure recipe to promote growth.
But problems soon developed. Raising taxes, especially personal income taxes, proved to be more difficult than anticipated. Public investment turned out to be less productive than assumed. notably as the capital output ratios turned out to be very high. Tax incentives often stimulated the wrong types of private investments and also contributed to corruption and rent-seeking behaviours.
Some economists started to argue that current public spending (especially spending for education and health) could be as productive as investment in infrastructure. Other economists called attention to the importance of the quality of public institutions seen necessary for promoting good economic policies. Attention also shifted from policies to institutions, and from investment in infrastructure to “productive”, current, public spending. Educational spending came to be seen as essential for improving the income distributions. It became an article of faith, among many economists, that higher literacy would directly lead to better income distribution, in addition to contributing to higher growth rates. Yet, as literacy went sharply up, income distribution did not change much in most countries while the impact of literacy on growth remained uncertain.
Tax reform continued to receive much attention, to make the tax systems: (a) more productive; (b) more efficient; and (c) more equitable. Lots of technical assistance was provided to developing countries by international and bilateral partners. There was definite progress in tax structures. For example, taxes on foreign trade became progressively less important, thus reducing distortions in the allocation of resources. Excise duties became more concentrated among items that were inelastic in demand and that, when consumed, generated negative externalities. The value added tax became an important and more efficient revenue sources in most countries.
However, the tax-to-GDP ratio did not change much, on average, remaining around 18 percent of GDP for the developing countries as a group. Also the revenue importance of the personal income tax did not change over the years and tax systems did not become progressive. The income tax remained unproductive and not-particularly equitable because most of the revenue from it came from taxes on wages and not from capital incomes or wealth. The low tax revenues were attributed to high tax evasion rather than to inadequate laws.
Over the years, many economists gave up on the possibility that the tax system could play a significant role in improving income distribution and shifted their attention to the spending side of the public budget. Many came to believe that desirable changes in the income distribution could be achieved more easily from the spending side of the budget, by giving more importance to particular categories of spending. For advanced countries the focus was on total public spending. For developing countries it was on more focused spending.
The above change of emphasis raises several questions. How efficient are governments in their spending activities? How good are the existing “public expenditure management systems”? Do they protect spending allocations from the influences of (a) elections?; (b) family, political, religious, or tribal connections?; and (c) corruption? Do the statistical studies on the incidence of public spending on income distribution take account of inefficiency? Are these studies influenced by biases, classifications, and preconceived notions on the part of the analysts?
Is it true that it is easier to redistribute income from the spending side than from the revenue side of the budget? Is there convincing evidence for this notion? Have we abandoned too quickly the objective of progressivity in taxation? If it is not possible to have progressive tax systems, is it possible to have, except at a small margin, expenditure programs that are truly pro-poor?
An issue that should worry economists is the extent to which those who deliver the social services to the poor (in education, health, etc.) may appropriate part, or even a large share, of the spending through inefficiency (i.e. school teachers or nurses that do not show up), or corruption. There is a lot of evidence from many developing countries that a significant share of the social spending often leaks in this way and does not reach those it was intended to benefit, but to whom the benefits of the spending are attributed.(1)
Another relevant question is whether the “fiscal space” that may be available to some countries should be used to raise the consumption (or the income?) of the poor; or to improve the quality of some essential public institutions; or the availability of infrastructures important to the poor?
On a different topic, much more coordination among countries is necessary to reduce the tax avoidance, that exists and that has been growing at the global level, to be able to raise higher tax revenue for developing countries. The time may have come to begin considering seriously the possibility of creating a World Tax Organization that might assist countries in the coordination of tax systems and in the surveillance over abusive tax changes. Such an organization would do for taxes what the World Trade Organization does, or attempts to do, for trade.
When creating pro-poor programs, it is important to look out for potential free riders, (beside those who deliver the services), that might appear within those claiming to be “the poor”. It is important to keep in mind a universal rule that states that: “if you want less of something, tax it. If you want more, subsidize it”. Pro-poor programs, unless they are strictly controlled, will attract “poor” people who are strictly not poor, or not so poor as the originally intended beneficiaries. This swelling will increase the costs of the programs and will also create “horizontal” inequities among the beneficiaries of the programs. As a priest once put it: “to give equal response to unequal needs can generate great injustice”.
As a general rule, the longer a program remains in existence, the more likely it is that less deserving people will push their ways into it. Over the long run the standards for admissions to the programs will be relaxed legally, administratively, or, de facto, through poor governance, or even through explicit corruption. Thus the differences in the genuine “needs” between the originally intended beneficiaries of the programs and the latecomers (who may be considered “free riders”) will become significant. This will create injustice and growing public costs. Some examples of these problems are easily available. They are common for programs for school lunches; for pensions for invalidity; for unemployment programs; and for others.
This characteristic of programs, that swell after they are introduced, thus becoming more expensive and less “equitable”, must be considered a “general law of public expenditure growth”. To prevent this effect, the population originally intended to benefit from a new public spending programs must be well - defined and its original, defining characteristics must not be allowed to change.(2)
In conclusion, let us recognize that the move from relying on taxes to relying on spending, to improve Gini coefficients, represents the latest thinking or even the latest fad. We should not be carried too far by it and should continue to pay full attention to both sides of the budget. Both sides should play a role in redistributing income. However, they can play this role only if they have the support of good institutions.
Some of Vito Tanzi's publications on the topic:
- 2011, Government versus Markets: The Changing Economic Role of the State (Cambridge University Press).
- 2008, “The Role of the State and Public Finance in the Next Generation”, OECD Journal of Budgeting, June
- 1974, “Redistributing Income through the Budget in Latin America”, Banca Nazional del Lavoro Quarterly Review, March
- 1972, “Fiscal Reform in Colombia: The Report of the Musgrave Mission”, Inter-American Economic Affairs, Summer
- 1968, “Governments ‘Approaches to income Redistribution”, National Tax Journal, December.
- 1966, “Personal Income Taxation in Latin America: Obstacles and Possibilities” National Tax Journal, Vol. 2, July.
Vito Tanzi is Former Director of the IMF’s Fiscal Affairs Department.
This article was published in GREAT Insights Volume 1, Issue 3 (May 2012)
1. Vito Tanzi,1974, “Redistributing Income through the Budget in Latin America”, Banca Nazional del Lavoro Quarterly Review, March.
2. The same law applies to some regulations. See for an interesting example the special preferential car tags given in some cities to progressively larger groups of citizens (handicaps, doctors, clerics, military, politicians, high level bureaucrats, etc.)..