Global Development Institute Blog

By Professor Armando Barrientos

Perhaps the greatest failing of the Millennium Development Goals was their focus on aid as the main financing tool for development.  This ‘cosmopolitan’ perspective has often misdirected attention away from basic fiscal policy in developing countries, which has a much greater impact on the lives of citizens.

Taxes and transfers are the most important instrument at our disposal to redistribute opportunity in low- and middle-income countries. Yet research and policy debate on international development has failed to maintain a consistent focus on fiscal policy. The extensive international consultations around the Sustainable Development Goals may have produced a rather unwieldy list of 17 ‘priorities’, but it has given an opportunity to re-establish the centrality of national tax and spending policies within the development agenda.

National governments collect taxes from citizens and companies, then deploy these resources to provide transfers in kind – through public provision of services like education, health care, sanitation – or transfers in cash – pensions, family allowances, disability benefits or scholarships.  Even in low income countries domestic tax collection far outweighs international aid.

Where governments get it right, fiscal policy supports human development and economic growth leading to poverty eradication and low inequality. Where governments get it wrong, human development and growth stagnate, leading to high levels of poverty and inequality.

Getting it right or getting it wrong are not just a matter of technical advice (although this is essential), but primarily a matter of politics and institutions. There are many different ways for countries to establish effective fiscal policy – reforms that work in one country may be ineffective in the next. The important role of institutions in fiscal policy suggests a degree of path dependence. Citizens and companies are more likely to pay taxes if they perceive fiscal policy to be fair and effective.

In evaluating fiscal policy it is imperative to start from the whole, not the parts.

Initiatives like Commitment to Equity led by Nora Lustig provide valuable insights into the distributional outcomes of taxes and transfers for a growing number of middle-income and low-income countries.  Based on responses to household surveys, they identify the incidence of taxes and transfers in cash. Transfers in kind are estimated from household demographics and aggregate budgets, for example children are allocated schooling costs. Overall, they find that the redistributive effects of fiscal policy in low- and middle-income countries are small, relative to high-income countries, and vary significantly across countries.

Fiscal policy is equalising in middle-income countries, but not by much. Redistribution is measured as the difference in the Gini coefficient of market income and final income after accounting for the effects of fiscal policy. Using survey data from 2014/5, they find that fiscal policy is responsible for a reduction in the Gini of less than 1 percentage point in Colombia and Indonesia; around 4 percentage points in Brazil Chile and Mexico; and over 7 percentage points in South Africa.Interestingly, the paper finds that fiscal policy is not always poverty reducing, especially due to the incidence of indirect taxes among people living in poverty.

The challenge facing low – and middle – income countries is to strengthen the redistributive capacity of fiscal policy. There are several areas of policy relevant to achieving this objective, but here we can only mention a few of them.

For most countries, raising tax revenues as share of GDP is a priority. In low-income countries, this is particularly hard to achieve. Improvements in tax administration are needed, but they are more likely to be effective if associated with third party information (payroll, business registration, etc.) And as the example of Brazil demonstrates, social and fiscal contracts are essential to raise tax/GDP ratios.

The tax mix is important too. Low- and middle-income countries rely to an important extent on consumption taxes and revenues from natural resources. The bulk of direct tax revenue collection comes not from personal income tax, but from corporate taxation.

Revenues from natural resources can generate a political resource curse because they insulate elites from the need to persuade citizens to pay taxes. Indirect taxes are easier to collect than direct taxes, but they tend to be regressive – hitting the poorest hardest. The challenge is to find innovative ways of countering the political resource curse, through strong fiscal contracts; and of making consumption taxes less regressive through differential rates or rebates.

On the transfer side, the expansion of social assistance transfers shows the way forward. Strengthening redistribution to low income groups through transfers in cash and through access to public services are an effective way to ensure fiscal policy contributes to growth and human development.

The Sustainable Development Goals have the potential to help shift the international development agenda away from its obsession with aid. Placing greater emphasis on the fundamentals of domestic tax and spending would mark a transformation in how ‘development’ is understood, particularly in the West. As the Goals are finalised in New York, it will be interesting to see if the ‘development community’ will become a bit more honest about how development actually happens.