1

Interaction of Tax and Aid

Sanjeev GuptaDeputy Director

Fiscal Affairs Department, IMF

Fourth ITD Conference, December 7-9

New Delhi

2

Relevance

Trends in tax revenues and aid flows

Empirical findings

Another dimension

Policy conclusions

Outline

3

Net foreign aid to developing countries has averaged between 3.7% and 6.7% of GDP during 1980-2009

Net foreign aid has averaged between 20% and 40% of tax revenues

Concern in the literature about aid dependency

Relevance

4

Impact of uncertain aid on budget planning Impact on incentives to strengthen tax systems

(by promoting rent seeking) and to build institutions

Thus aid can substitute for domestic revenues The implications of aid substitutability are:

Aid can adversely affect fiscal consolidation efforts through reduced revenues

More than estimated resources would be needed for MDGs; and

Shift the burden of taxation to donor countries

Relevance

5

Tax revenue in low- and middle-income countries, 1980-2009

Trends in Tax Revenue and Net Aid

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1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Average Total Tax Revenue % GDP

Low income

Lower middle income

Upper middle income

…Tax Revenues Have Remained Broadly Stable in Two Groups

Note: Economies are divided among income groups according to 2009 gross national income (GNI) per capita, calculated using the World Bank Atlas method. The groups are: low income, $995 or less; lower middle income, $996–3,945; upper middle income, $3,946–12,195.

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1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

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1998

1999

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2009

10

12

14

16

18

20

22Average Total Tax Revenue % GDP

East Asia Pacific & South Asia Latin America & Caribbean

Middle East & North Africa Sub-Saharan Africa

…. Little Progress in Three Regions

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A simple plot suggests a negative association between net ODA and tax revenues

Trends in Tax Revenue and Net Aid

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Note: Tax revenue is measured on the left axis, while total ODA is measured on the right axis.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

10.0

11.0

12.0

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14.0

15.0

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20.01

98

01

98

11

98

21

98

31

98

41

98

51

98

61

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71

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81

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91

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92

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32

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42

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52

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72

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82

00

9

Tax Revenue Total ODA (net)

Percent of GDP

Average Net ODA and Tax Revenue in Low and Middle Income Countries, 1980-2009

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Studies are split between negative and positive effects of aid on domestic revenue mobilization

Some studies have also examined the relative effect of grants and loans on the domestic revenue performance

The assumption is that recipients view grants and loans differently

Empirical Findings

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The earlier results showed that a dollar increase in overall aid (net loans and grants) was associated with a decline in domestic revenues

The composition of aid also matters

ODA in the form of loans is associated with higher tax revenues; converse holds for grants

These results were challenged in more recent studies

Empirical Findings

12

However, the results using updated data and that address many of the criticism support the previous conclusions

But the impact is weakening (the offset for grants was 28 percent for every dollar. It is now 8 percent)

Why? Countries are making efforts to raise more

revenue given pressing needs Figure 2 shows structural benchmarks and

indicative targets in the IMF-supported programs for low-income countries since 2002-2003

Empirical Findings

13

Notes:Indicative targets (IT) refer to quantitative targets that the program is designed to achieve, but is not a prerequisite for continued disbursements. e.g., Fiscal deficit, Floor on revenues, Floor on priority spendingStructural benchmarks (SB) can be legal, institutional or policy measures that are relevant for a program's macroeconomic obj ectives. e.g., Introduction of Tax Identification Number, Increase of VAT Threshold, Establishment of a Large Taxpayer Unit, Reduction/elimi nation of tax exemption

Source: IMF

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13 10

114

30 18

259

79

44

285

84

52

0

50

100

150

200

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300

2002-03 2007-08 2009-10 2010-11

Total SB Total IT

Fiscal SB Fiscal IT

Revenue SB Revenue IT

Structural Benchmarks and Indicative Targets

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Does the above inverse relationship hold when we disaggregate tax revenues? No study has done this until now

First, plots of different tax revenues and net ODA

Empirical Results

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08

3.0

3.5

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8.0

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3.5

4.0

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6.0

6.5

7.0

7.5

8.0

Income taxes

Total ODA (net)

Percent of GDP

Average Taxes and Total Net ODA, 1980-2009

Note: Tax Revenues are measures on the left axis and Total ODA on the right axis.Source: Author’s calculations based on the IMF’s FAD Revenue Mobilization database and OECD DAC database

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80

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81

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82

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84

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09

3.0

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8.0

3.0

3.5

4.0

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6.0

6.5

7.0

7.5

8.0

VAT

Total ODA (net)

Percent of GDP

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80

19

82

19

84

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86

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90

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92

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1.0

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1.0

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Excises

Total ODA (net)

Percent of GDP

Average Taxes and Total Net ODA: 1980-2009

Note: Tax Revenues are measures on the left axis and Total ODA on the right axis.Source: Author’s calculations based on the IMF’s FAD Revenue Mobilization database and OECD DAC database

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80

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82

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84

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3.0

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8.0

Trade tax

Total ODA (net)

Percent of GDP

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The results show that net aid has a negative relationship with VAT, excise and income taxes

Grants are negatively associated with these taxes with the offset of 12 percent for VAT—the highest among the three taxes

Significant revenue potential has been estimated from strengthening VAT productivity, adjusting excises, and eliminating tax exemptions

But ODA is positively associated with trade tax revenues

Empirical Findings

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Disaggregating the sample shows that results hold for countries in sub-Saharan Africa and for low-income countries

However, a higher level of grants ends up almost fully displacing domestic tax revenues in countries with weak institutions

These results are similar to those in the previous study

Empirical Findings

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Similar results hold for hydrocarbon producers

An additional percentage point of revenue from hydrocarbons reduces revenues from other domestic sources

Interestingly, the effect of grants on non hydrocarbon revenues is negative.

Another Dimension

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Despite some success cases (e.g. Tanzania, El Salvador, Vietnam) domestic resource mobilization continues to be below potential in many countries

Aid flows can influence the incentive structure of aid recipients and empirical studies show that is the case in SSA and low-income countries in particular

The impact is relatively large for VAT

Policy Conclusions

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The good news is that the overall impact is modest and weakening for countries with relatively strong institutions

This reflects increasing attention being paid to revenue mobilization under reform programs in many countries

However, the continuing almost full displacement of domestic tax revenues in countries with weak institutions is a source of concern

Finally, the negative relationship between hydrocarbon revenues and other domestic revenues found in natural resource producers suggests that these countries will face significant costs in moving to a higher level of domestic taxation once domestic resources are depleted

Policy Conclusions

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Thank you!

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Country Income Categories

Low incomeBangladesh, Benin, Burkina Faso, Burundi, Cambodia, Central African Rep., Chad, Comoros, Congo, Dem. Rep. of, Eritrea, Ethiopia, Gambia, The, Ghana, Guinea, Guinea-Bissau, Haiti, Kenya, Kyrgyz Republic, Lao People's Dem. Rep, Liberia, Madagascar, Malawi, Mali, Mauritania, Mozambique, Myanmar, Nepal, Niger, Rwanda, Sierra Leone, Solomon Islands, Tajikistan, Tanzania, Togo, Uganda, Zambia, Zimbabwe

Lower middle incomeAngola, Armenia, Belize, Bhutan, Bolivia, Cameroon, Cape Verde, China, P.R.: Mainland,Congo, Republic of, Côte d'Ivoire, Djibouti, Ecuador, Egypt, El Salvador, Georgia, Guatemala, Guyana, Honduras, India, Indonesia, Jordan, Kiribati, Lesotho, Maldives, Moldova, Mongolia, Morocco, Nicaragua, Nigeria, Pakistan, Papua New Guinea, Paraguay, Philippines, Samoa, Senegal, Sri Lanka, Sudan, Swaziland, Syrian Arab Republic, São Tomé & Príncipe, Thailand, Tonga, Tunisia, Ukraine, Uzbekistan, Vanuatu, Vietnam, Yemen, Republic of

Upper middle incomeAlbania, Algeria, Antigua and Barbuda, Argentina, Azerbaijan, Rep. of, Belarus, Bosnia & Herzegovina, Botswana, Brazil, Bulgaria, Chile, Colombia, Costa Rica, Dominica, Dominican Republic, Fiji, Gabon, Grenada, Iran, I.R. of, Jamaica, Kazakhstan, Lebanon, Libya, Lithuania, Macedonia, FYR, Malaysia, Mauritius, Mexico, Namibia, Panama, Peru, Russian Federation, Seychelles, South Africa, St. Kitts and Nevis, St. Lucia, St. Vincent & Grenadines., Suriname, Turkey, Uruguay, Venezuela, Rep. Bol.

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Benedek, Dora, Sanjeev Gupta, and Priscilla Muthoora, 2011,“Foreign Aid and Revenue: Still a Crowding Out Effect?” Forthcoming IMF Working Paper.

Bornhorst, Fabian, Sanjeev Gupta, and John Thornton, 2009, “Natural Resource Endowments and the Domestic Revenue Effort,” European Journal of Political Economy,” Vol. 25, pp. 439–46.

Brautigam, Deborah, and Stephen Knack, 2004, “Foreign Aid, Institutions, and Governance in Sub-Saharan Africa, “Economic Development and Cultural Change, Vol. 52 (January) pp. 255–85.

Clist, P. and O. Morrissey, 2011, “ Aid and Tax Revenue: Signs of a Positive Effect since the !980s,” Journal of International Development, 23, 165-180

Gupta, Sanjeev and Shamsuddin Tareq, 2008, “Mobilizing Resources,” Finance and Development, September 2008.

Gupta, Sanjeev, Benedict Clements, Alexander Pivovarsky, and Erwin R. Tiongson “Foreign Aid and Revenue Response: Does the Composition of Aid Matter?” Chapter 14 in “Helping Countries Develop: The Role of Fiscal Policy,” edited by Sanjeev Gupta, Benedict Clements, and Gabriela Inchauste (Washington: International Monetary Fund), 2004.

Gupta, Sanjeev, Benedict Clements, Emanuele Baldacci, and Carlos Mulas-Granados, 2004, “The Persistence of Fiscal Adjustments in Developing Countries,” Applied Economics Letters, Vol. 11 (March). pp. 209–12.

References

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Heller, Peter S., 1975, “A Model of Public Fiscal Behavior in Developing Countries: Aid, Investment, and Taxation,” American Economic Review, Vol. 65 (June), pp. 429–45.

IMF, 2011, “Revenue Mobilization in Developing Countries”, available at www.imf.org/external/np/pp/eng/2011/0308011.pdf

Khan, Haider, and Eiichi Hoshino, 1992, “Impact of Foreign Aid on the Fiscal Behavior of LDC Governments,” World Development, Vol. 20 (October), pp. 1481–88.

McGillivray, Mark, and Akhter Ahmed, 1999, “Aid, Adjustment and Public Sector Fiscal Behavior in the Philippines,” Journal of the Asia-Pacific Economy, Vol. 4, No. 2, pp. 381–91.

Moss, T., G. Pettersson, and N. van de Walle, 2008, An Aid-institutions Paradox? A Review Essay on Aid Dependency and State Building in Sub-Saharan Africa. In W. Easterly (Ed), Reinventing Foreign Aid, Cambridge, MA: The MIT Press.

Odedokun, Matthew, 2003, “Economics and Politics of Official Loans versus Grants,” WIDER Discussion paper No. 2003/04 (Helsinki: United Nations University, World Institute for Development Economics Research).

Remmer, K, 2004, “Does Foreign Aid Promote the Expansion of Government?” American Journal of Political Science, 48, 77-92.

References