Mobilizing tax revenue is key if developing countries are to finance the investments in human capital, health and infrastructure necessary to achieve the World Bank Group’s goals of ending extreme poverty and boosting shared prosperity by 2030. To achieve the Sustainable Development Goals, low-income countries face an estimated annual financing gap of half a trillion dollars, 0.5 percent of global Gross Domestic Product (GDP). The International Monetary Fund (IMF) estimates that extra tax revenues could finance one-third of this gap.
The global economy is, literally and metaphorically, staring down the barrel of a gun. Stopping the war in Ukraine, rebuilding its economy and delivering a lasting peace settlement must be the priorities. But the international community will also need to deal with the widespread economic damage that the conflict is already causing in many parts of the developing world; damage that will only intensify as the conflict persists. Recalling George Marshall’s response to the challenges of an earlier post-conflict world, the truth of the matter is that for a significant number of countries, the financial requirements for the next few years are so much greater than their present ability to pay that substantial additional help will be needed to mitigate economic, social, and political deterioration of a very grave character.
The year 2022 already appeared to be one of decelerating and uneven growth. The unprecedented policy measures that helped economies around the world recover from the paralysis of the covid pandemic have been asymmetric in their effects and short-term in scope, adding new challenges to an already testing policy environment. As we argued in September 2021 (TDR 2021), a return to pre-2020 conditions should not be the goal of policymakers. It would diminish the hope of achieving more inclusive and sustained growth and undermine the task of building economic resilience in the era of climate change. The threat of repeating the policy mistakes of the past is, however, rising as the fallout from the conflict in Ukraine spreads beyond its borders.
The economic, financial and political reverberations from the war are unfolding at a turning point in global policy discussions, as the supportive public policy stance necessitated by the pandemic gives way to fiscal and monetary tightening. In the advanced economies, central banks are beginning to raise interest rates from historic lows and selling some of the assets they purchased during the decade of quantitative easing. Budgetary authorities, having issued large volumes of government debt during the pandemic, are turning their focus to reducing primary balances by raising taxes and cutting spending.
In the face of long-standing structural problems and new geopolitical risks, macroeconomic tightening in the North, along with a general weakening of multilateral rules and practices, is set to stymie growth across developing economies, particularly those that are closely integrated into the global financial system. This will not only endanger their fragile recovery, but also undermine their long-term development.
Already in the closing months of 2021, inflationary and exchange rate pressures began to trigger monetary tightening in a number of developing countries, with expenditure cuts anticipated in upcoming budgets.
A likely effect of the conflict in Ukraine is an acceleration and widening of these measures, with the purpose of retaining volatile foreign capital.
Two immediate impacts of the war in Ukraine have been exchange rate instability and surging commodity prices, particularly for food and fuel. The added pressure of price increases is intensifying calls for a policy response in advanced economies, including on the fiscal front, threatening a sharper than expected slowdown in growth.
Mobilization of domestic resources in recognized as the foundation for self-sustaining development. Domestic resources are important in financing domestic investment and social programmes, which are essential for economic growth and for eradicating poverty. Financing for economic growth and poverty reduction is one of the challenges facing the least developed countries (LDCs). Due to inability of domestic resource to meet the financing requirements, these countries have resorted to external sources to finance development projects and social programs. However, domestic resource mobilization can be managed more innovatively for greater effectiveness. In this context, a sound fiscal policy, responsible social spending and a well-functioning and competitive financial system are the crucial elements for economic and social development.
MOBILIZE RESOURCES TO IMPROVE DOMESTIC REVENUE COLLECTION
Effective tax policies should ensure that profits are taxed where economic value is created and that corporate income tax is levied according to where economic activity takes place. Predictable tax rules are essential for cross-border trade, business investment, jobs and growth; all of which enable the mobilization of resources through revenue collection. In developing countries, the tax revenue accrued from private sector investment is especially valuable.
Economic growth must be inclusive to provide sustainable jobs and promote equality.
Tax policies are instrumental in reducing inequality both within and among countries. ICC believes that tax policies should be designed to support sustainable economic development, reduce inequality and promote inclusive growth.
To reduce inequalities, policies should be universal in principle, paying attention to the needs of disadvantaged and marginalized populations.
Tax policies that promote investment and innovation, particularly in developing economies, go a long way towards attracting foreign direct investment (FDI). Research shows that FDI plays an often-critical role in driving productivity and output growth in both developed and developing economies.
Sustainable economic growth will require societies to create the conditions that allow people to have quality jobs.
To achieve a balanced and efficient tax system that provides for the effective, accountable and transparent institutions that the SDGs call for, greater cooperation between governments and the business community is essential.
The danger for many developing countries that are heavily reliant on food and fuel imports is more profound, as higher prices threaten livelihoods, discourage investment and raise the spectre of widening trade deficits. With elevated debt levels from the pandemic, sudden currency depreciation can quickly make debt service unsustainable and tip some countries into a downward spiral of insolvency, recession and arrested development.
Whether this leads to unrest or not, a profound social malaise is already spreading. As a result, the global economy, having entered 2022 on a “two-speed” recovery path, will not only shift down a gear in terms of growth, but will also see many developing countries lose ground to advanced countries, while their vulnerability to shocks is heightened by rising geo-political tensions and deepening economic uncertainty.
The risks to countries’ financial systems are further amplified by the pressure to “rebuild fiscal buffers” by cutting non-military government spending. In fact, as discussed in previous Trade and Development Reports, attempts to create fiscal space through budget cuts are bound to backfire. Building resilience requires reinforcing aggregate demand through investment and social protection, in a framework of appropriate multilateral institutions.
Sub-Saharan Africa remains the region with the largest number of economies below the minimum desirable tax-to-GDP ratio of 15%. At that level, revenues are inadequate to finance basic state functions. Non-oil-rich countries in the region saw their tax-to-GDP ratios increase to 16% in 2018 from 15.3% in 2010. Due to fluctuating oil prices, tax collections are more volatile in oil-rich states. In these countries, tax revenues increased from 9.2% of GDP in 2010 to 15.2% in 2015, after which taxes fell back to 10.2% in 2018.
Relatively low tax collections in the region reflect weaknesses in revenue management, including widespread tax exemptions, corruption, and shortfalls in the capacity of tax and customs administrations. Given the region’s relatively large agricultural sectors and less open economies, the capacity to raise tax revenues is also lower. The maximum tax revenue potential for countries in the region is estimated to average 19.6% of GDP, which is 7.5 points lower than in the rest of the world.
Most African economies have the potential to mobilize more in taxes. This can be done through better tax administration (including value-added taxes), broadening the tax base by removing cost-ineffective tax expenditures, and increasing excise taxes (including on alcohol, tobacco, and soft drinks). In addition, it’s important to introduce efficient carbon-pricing policies and effective property taxation while and closing international tax loopholes that permit aggressive tax avoidance and evasion by multinationals and wealthy individuals.
Reducing structural bottlenecks is also part of suite of tools to consider in improving revenue outcomes, including by improving taxpayers’ trust and by moving tax administrations to the digital frontier.
Achieving the Sustainable Development Goals by 2030 requires a big increase in investment. That poses a challenge for many countries in Sub-Saharan Africa, where most economies collect taxes that amount to less than 15 percent of GDP—barely enough to carry out the most basic state functions. The World Bank Group is helping these countries mobilize domestic resources fairly and efficiently—with a focus on administering value-added taxes, removing cost-ineffective tax expenditures, increasing excise taxation, improving property taxation, and closing international tax loopholes for multinationals and wealthy individuals.
Domestic revenues can lead to improved development only if they are translated into productive and beneficial public expenditure. For this reason, both sides of the fiscal equation—revenue and expenditure—need to be examined together. However, both governments and donors tend to analyze revenue generation and public spending separately, except when it comes to their joint effects on macroeconomic stability and income inequality. As a result, either revenues are taken as given or spending is considered without addressing the tax policy and administrative measures needed to yield the requisite resources.
Domestic resource mobilization (DRM) has become a core priority of the sustainable development agenda. The 2015 Addis Ababa Action Agenda on
Financing for Development emphasized the importance of DRM, noting that the “mobilization and effective use of domestic resources ... are central to our common pursuit of sustainable development.” On the revenue side, the only reliable and sustained sources of government revenue are taxes and some non-tax revenue instruments, such as royalties and resource rents from extractive industries and, to a limited extent, user fees for public services, generally delivered by local governments. Public sector investments through state-owned enterprises have not been a reliable source of revenue in low- and middle-income countries (LMICs); instead, they have often been a drag on the budget.
On the expenditure side, legal obligations often make it difficult to lower administrative overhead, curtail debt servicing, and reduce transfer payments. Thus, lack of sufficient domestic revenue mobilization often results in the cutback of new capital assets and the poor maintenance and operation of existing assets. These cutbacks have an adverse impact on both the level and the quality of present-day services as well as the rate of future economic growth and development.
In most LMICs, particularly low-income countries (LICs), government revenues fall short of the rising need for public expenditures and have to be
supplemented through borrowing, multilateral development assistance, or both. Excessive public borrowing from domestic sources can crowd out borrowing and investments by the private sector, with adverse effects on economic growth.
Foreign borrowing inherently raises the interest rate on future debt and often leads to high indebtedness. In order to service the loans and avoid falling into a debt trap, the funds borrowed from abroad must be invested in projects and programs that are productive and economically viable. Such Investments require capacity for project appraisal and expenditure analysis on the part of line ministries and the ministry of economy and planning, which is weak in many LMICs.
Domestic Resource Mobilization as an Instrument of Sustained and Inclusive Development
Official development assistance (ODA) is clearly finite and fluctuates over time, creating uncertainty for recipient countries about planning, budgeting, and expenditures in the public sector. Thus, a chronic and substantial dependence on debt and foreign aid raises serious concerns about the sustainability of government spending and its implications for future economic growth. ODA has uncertain impacts on long-term DRM. Grants may fully displace domestic revenues, but a better understanding of the links between foreign assistance and domestic revenues is needed so that aid supports countries’ own efforts to generate tax revenue. Continued, long-term dependence on aid is unlikely to be conducive to enhanced DRM.
Taxation as a Plank of State Building
The state-building process involves ongoing negotiations between the state and its citizens. On the one hand, tax reform is influenced and guided by the political economy; on the other hand, taxation can be instrumental in the state-building process in a variety of ways, particularly in LMICs. As government depends on taxes and on the prosperity of the people, it has a strong incentive to promote economic growth and engage with the public. This dependence leads to accountability and responsiveness on the part of the state.
Taxation may also help to introduce good practices within different parts of government. For example, in many countries, the introduction of unique tax-payer identification numbers has strengthened other parts of the public and private sectors, including municipal governments and commercial banks. Tax systems build databases that are essential for broader economic and administrative management. Tax reforms emphasize merit-based hiring and performance management, which are highly relevant to other agencies and departments in government. Tax reform should, therefore, be seen as an essential part of state building.