18 November 2016
How do states learn to tax? The capability to raise revenues from taxes – called ‘fiscal capacity’ in recent research on the analysis of the state – is a crucial aspect for the functioning of every state and is important to economic development for two reasons.
Firstly, greater fiscal capacity implies greater access of the state to resources that are needed for public goods provision. Developing countries are only able to raise a small share of taxes over GDP, whereas they would need higher revenues in order to invest in a number of economic and social areas that are crucial for their growth. Secondly, greater fiscal capacity is usually associated with the creation of a civilian bureaucracy that can itself become a distinct and powerful societal force, and provide an enabling environment for more capable states.
In our working paper, ‘How do political institutions affect fiscal capacity? Explaining taxation in developing economies’, we unpack the concept of fiscal capacity, distinguishing between two aspects of taxation power: the accountability and transparency of fiscal institutions, which we call impartiality; and their effectiveness in extracting revenues. Drawing from the institutional economics and political science literature, we posit that political systems that place strong constraints on the executive power would be more likely to lead to taxation systems that have a higher degree of impartiality.
In such political systems, non-state actors can control and limit elites’ access to resources, and are able to demand greater accountability on the part of the state with respect to the taxes they pay. Therefore, greater constraints on the executive are expected to have a positive effect on the impartiality of the taxation system. In contrast, rational political elites – in both authoritarian regimes with limited constraints on the executive, and democratic regimes with stronger constraints on the executive – are likely to invest in the effectiveness of the tax system in order to mobilise greater revenues, either for their own benefit or for greater public goods provision. Therefore, we would not expect any clear relationship between greater constraints on the executive and the effectiveness of the tax system.
To test the above hypotheses, we use a recently created set of indicators provided by PEFA, the Public Expenditure and Financial Accountability project developed by a number of national and international organisations (such as the International Monetary Fund and the World Bank). These indicators allow us to unpack fiscal capacity and evaluate its two core dimensions – the impartiality and effectiveness of the taxation system. Among the variables concerned with impartiality, we included:
- Transparency of taxpayer obligations and liabilities, which evaluates taxpayers’ access to information on tax liabilities and administrative procedures;
- Tax appeals, assessing the functioning of a tax appeals mechanism;
- Controls in the taxpayer registration system, assessing the quality and maintenance of a taxpayer database.
In the group of variables related with effectiveness, we considered:
- Effectiveness in collection of tax arrears: it is the collection ratio for gross tax arrears, being the percentage of tax arrears at the beginning of a fiscal year, which was collected during that fiscal year;
- Effectiveness of penalties for non-compliance: it addresses failures in registration and tax declaration obligations, assessing whether penalties for all areas of non-compliance are set sufficiently high to act as deterrents and are consistently administered;
- Effectiveness in collection of tax payments: looking at the frequency of complete accounts reconciliation between tax assessments, collections, arrears records and receipts by the Treasury.
Using cross-national data for 47 developing countries, we find the existence of constraints on the executive power (our measure for a limited government) increases the impartiality in the tax system, whereas this variable is often insignificant in explaining the effectiveness of the tax system. We also find that the channels through which the constraints on the executive impact on the impartiality dimension of fiscal capacity are the rule of law, and the performance of the bureaucracy.
Our findings suggest that measures that improve the impartiality of taxation systems may be more important in raising tax revenues in developing countries than measures that only focus on raising the effectiveness of such systems. Furthermore, to build such fiscally capable states, a key route is the consolidation of cohesive political institutions, providing strong checks and balances on the discretionary power of the executive.