Addiction to debt forgiveness in developing countries: Consequences and who gets picked?

• Date: 01 May 2019
• Author: Jorge Martinez‐Vazquez,Leanora Alecia Brown
• DOI: http://doi.org/10.1111/rode.12575
• Published date: 01 May 2019

REGULAR ARTICLE

Addiction to debt forgiveness in developing

countries: Consequences and who gets picked?

Leanora Alecia Brown

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Jorge Martinez-Vazquez

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1

University of Tennessee, Chattanooga,

TN

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Georgia State University, Atlanta, GA

Correspondence

Leanora Alecia Brown, University of

Tennessee at Chattanooga, Department of

Finance and Economics, 615 McCallie

Avenue, c/o 413 Fletcher Hall,

Chattanooga, TN 37403.

Email: Leanora-brown@utc.edu

Abstract

We explore whether the expectation of debt forgiveness dis-

courages developing countries from attaining sustainable fis-

cal independence through improving their tax effort. While

the international financial community advises poor countries

to improve revenue mobilization, the same international

community routinely bails out poor countries that fail to meet

their loan repayment obligations, among other reasons as a

result of the low tax effort they exercise. The act of bailing

out creates an expectation about receiving debt forgiveness

time and again in the future. The key prediction of our theo-

retical framework is that in the presence of debt forgiveness,

countries’tax efforts will decline and more so the higher the

intensity of the bailouts. We test this proposition using data

for 55 countries from 1995 to 2015. We find that debt for-

giveness is significant in lowering tax effort. In addressing

the potential of reverse causality, we also find that the inter-

national financial community has been more forgiving to

countries that exert lower tax effort. These results, which are

robust to various specifications, have significant policy

implicationsfor donor and recipient countries.

JEL CLASSIFICATION

F35, H20, E60

KEYWORDS

soft budget constraint, debt forgiveness, tax effort, moral hazard

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INTRODUCTION

One of the most important development issues facing the international community for has been the

low levels of public expenditures in infrastructure and social services in developing countries.

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DOI: 10.1111/rode.12575

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© 2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/rode Rev Dev Econ. 2019;23:902–921.

Low levels of public spending in those areas may have been responsible for placing many of these

countries in a poverty trap. Breaking out of this trap requires, among others, a combination of

international aid in the form of technical assistance with low cost loans and increased sustained tax

effort by the developing countries themselves.

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However, international aid, especially when it is

accompanied with debt forgiveness, can interact with domestic tax effort in some perverse ways,

which can compromise the sustainability of these fundamental development goals. Even though

there has been considerable interest in the economic literature on the separate topics of tax effort

in developing countries,

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and international assistance and debt forgiveness,

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the interaction between

these two issues has not yet been thoroughly explored in the literature.

The issue of debt forgiveness has generated much debate in both the academic literature and poli cy

circles, and rightly so, since their success or failure helps to inform the design of subsequent initiatives.

Relative to the earlier initiatives, the newer ones sought to provide faster, deeper, and broader debt

relief.

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These more generous forgiveness terms sought to encourage physical capital accumulation that

would lead to higher incomes and tax revenues for the government. However, this chain of events is

not as straightforward as one may think because there is at least one inherent moral hazard problem

associated with the provision of debt forgiveness, and this will be the main focus of our paper.

The primary question we consider is whether the expectation of debt forgiveness actually acts

to soften developing countries’budget constraint. That is, does the expectation of debt forgiveness

lower the financial discipline of recipients to the extent they may no longer have—other things

being the same—an incentive to bolster their own tax effort?

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We address the potential endogene-

ity of debt forgiveness by instrumenting it with geographical and cultural proximity variables

between donor and recipient countries and the HIV/AIDS rate in the recipient countries. Although

these instruments create exogenous variations in debt forgiveness flows, they are not directly corre-

lated with tax effort. Standard tests confirm their validity.

Addressing the reverse causality between debt forgiveness and tax effort raises an interesting

second research question. Whether countries with lower tax ratios are actually more likely to be

provided with more debt forgiveness.

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Investigating this question is also important from a policy

perspective. Is the international financing community saying one thing—advising developing coun-

tries to become more self‐reliant on their own taxes—but in reality practicing something very dif-

ferent—de facto discouraging those countries to increase their tax effort?

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Empirically, we find fresh new evidence that debt forgiveness does actually seem to trigger a

significant decline in the actual tax to GDP ratios, implying that debt forgiveness acts as a conve-

nient substitute for otherwise politically costly efforts to increase own tax efforts. We also find that

the international financial community actually has been more forgiving to countries that exert

lower tax effort, thus setting perverse incentives against an important objective this same interna-

tional financial community has been trying to accomplish for many years. These findings have sig-

nificant policy implications for donors and recipient countries.

The rest of the paper is organized as follows. Section 2 briefly reviews the related literature on

tax effort and debt forgiveness. Section 3 presents a descriptive analysis of debt forgiveness and a

simplified conceptual framework. The empirical model and a discussion of the data follow in Sec-

tion 4. The estimation results are discussed in Section 5, while the conclusions and policy implica-

tions are presented in Section 6.

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LITERATURE REVIEW

Tax revenues are essential for providing public goods and services in a sustainable manner. For

Kaldor (1963) the key indicator of whether a country can transition from a position of aid

BROWN AND MARTINEZ‐VAZQUEZ

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