Development aid should factors in more than tax ratios, expert says

For countries with low tax rates or lax enforcement of tax laws, the air is growing increasingly thin. Against the background of the present global financial and economic crisis, so-called tax havens are finding themselves faced with growing pressure to improve the transparency of their tax systems and discontinue unfair practices.

Also, developing countries are being called upon to do more to mobilize resources of their own. The European Commission, for instance, proposes to cut development funds for countries that fail to meet their commitments to establish good governance in tax matters. There are even some calls for discontinuation of development cooperation with countries whose tax ratio, which is the share of taxes and levies as a percentage of the gross domestic product, is below a threshold value that could be set at 20 percent.

Countries should also mobilize their own resources

In the international discussion there are mainly three reasons put forward for cutting development cooperation funds for countries with low tax ratios:

Legitimacy of development cooperation

It contradicts our sense of justice when we see donor countries using their tax resources to support developing countries whose governments do too little to mobilize resources of their own. This means the middle classes in donor countries compensate for the unwillingness of elites in developing countries to contribute to financing public goods and services.

Bad governance

The inability of political regimes to induce their elites to pay taxes may be read as an indication of poor governance in other areas too. In such cases development cooperation provides a contribution to further stabilizing political regimes with bad governance.

Rent-seeking

In many developing countries, development cooperation amounts to a rent that tends to impair development rather than to promote it. Governments may see no need to shoulder the burden of mobilizing resources of their own as long as they are able to fall back on external resources.

In such cases it is certainly not wrong to at least think about cutting development cooperation funding. But what countries are we talking about here, actually?

International comparison

It is not really possible to identify low-revenue countries on the basis of a fixed tax ratio threshold. For example, if we used the 20 percent GDP figure as a basis, we would find that a clear-cut majority of the partner countries of German development cooperation fall below the threshold. While there are some exceptions, including Ghana (21.3 percent) and Jordan (24.3 percent), the trend still remains clear.

Furthermore, any attempt to set a rigid threshold value would be tantamount to overlooking the fact that a country's tax ratio tends to correlate closely with its per capita income. In other words, development cooperation needs to take account of the country's stage of development.

A trend line indicating the relation between tax ratio and income could be used for purposes of guidance. Countries with a tax ratio at or above the trend line would be seen as making better use of their taxation capacity than countries with a tax ratio below the trend line. Generally speaking, a good number of countries in sub-Saharan Africa are either at, or indeed above, the trend line. On the other hand, numerous countries in Latin America have poorer performance records - some of them significantly poorer.

Compared with a rigid threshold value, the trend line proves to be a better indicator of the ability or willingness of countries to collect taxes. However, observation over a protracted period of time to identify trends is required, and analysis of this kind often proves impossible for lack of proper data.

Conflicts impact on tax ratios

Apart from per capita income, there are other factors that influence tax ratios:

- Countries involved in an armed conflict or caught up in a post-conflict situation, or whose tax structures are fragile for other reasons, tend to have especially low taxation capacities.

- The economic structure also plays a role. For example, a country where the agricultural sector accounts for a high share of overall economic output tends to fall short of the trend, while countries with a high foreign-trade volume will tend to perform better.

Case-by-case approach necessary

In dealing with partner countries with a weak performance record on taxes, development policy needs to adopt a case-by-case approach. When countries are found to lie persistently and significantly below the trend line, it would be advisable to further analyze the reasons for their low tax ratios. A close look should be taken in particular at the composition of their tax regimes: Low direct taxes tend to be a signal for bad governance in this area.

Tax system reform should be placed on the agenda of development cooperation with countries that have low tax revenues, stagnant or deteriorating indicators, and a "bad" tax regime composition. According to the OECD, in 2007 less than .1 percent of public development cooperation funds was spent for tax-related tasks. That is certainly not enough to have any appreciable impact on existing incentive structures.

Targeted support is needed for fragile countries

Instead of being cut off from development cooperation, highly fragile countries or countries in a conflict or post-conflict situation should be provided targeted support in their efforts to strengthen their tax systems. Governments should be encouraged to boost their tax revenues. Conditioning budget support or other financial aid on improvements of their tax systems are two ways to do so.

If successes fail to materialize, and decision-makers in partner countries clearly lack the will needed for the purpose, donors will be forced to ask themselves how they can continue to justify to their constituencies at home their cooperation with the governments concerned.

Dr. Christian von Haldenwang (ara)

Editor: Sean Sinico

Dr. Christian von Haldenwang is a political scientist with in the Governance, Statehood, Security Department at the German Development Institute (DIE)

Based in Bonn, the German Development Institute draws together the knowledge of development research available worldwide, dedicating its work to key issues facing the future of development policy. It consults on the basis of independent research findings in Germany and worldwide and deals with current issues in cooperation between industrial and developing countries.