Fiscal composition and aid effectiveness: a political-economy model.

Author:Stewart, James

24 May 2012

Taxation, public expenditure and their relationship to aid effectiveness.

In a recent UNU-WIDER working paper 'Fiscal Composition and Aid Effectiveness: A Political-Economy Model' Paul Mosley examines the claim that aid would have, in the long term, a negative impact on the productivity and stability of expenditure in recipient countries, due to its tendency to undermine tax systems.

The importance of fiscal determinants of aid effectiveness

In this paper Mosley posits that fiscal performance is a crucial factor in determining the effectiveness of development aid in the long term. He defines fiscal performance as the level of productivity of public expenditure and the willingness of governments to finance that expenditure out of these taxes, rather than out of aid. Willingness to finance expenditure out of taxation is included because the long term tax based expenditure is more stable and productive than expenditure financed from development aid, which by definition must be discontinued as if the country is to become financially self-sustainable. Logically then aid will be more effective in improving fiscal performance, if it incentives, rather than substitutes for, the creation of tax revenue.

It is always politically costly to raise tax revenue and this is particularly true for poor countries with weak states. They therefore often rely on donors to finance additional expenditure through development aid. In these countries an evolution of the tax structure requires the elites to put long term developmental interests above those of short term political survival. It is thus clear that in order to understand how aid effectiveness can be improved we need to know what determines the likelihood of the elites in a recipient country taking a long term view in their policy making. The paper puts forwards four hypotheses to this effect.

The first hypothesis suggests that a move towards inclusive allocation of fiscal resources often occurs due to elites realizing that exclusiveness has consistently failed to deliver growth or political stability. This pattern is evident in the 1990s in Ghana, Mozambique, and Rwanda, at the turn of millennium in Sierra Leone, and more recently in Bolivia, Ecuador, Argentina, and Indonesia. In all these cases regimes learned from the experience of political trauma and instability and fundamentally modified their political system and fiscal regime.

The second hypothesis is that the introduction of policies...

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