In development circles these days, there is considerable emphasis on developing countries collecting more taxes domestically to help achieve the Sustainable Development Goals (SDGs). This makes sense: the resources required to finance development are enormous, and the current state of advanced countries’ public finances—with the average debt-to-GDP ratio above 100 percent—does not permit a major scaling up of aid budgets. This explains why SDG 17.1 tracks country-level domestic revenue mobilization efforts and why the Addis Agenda for financing for development prominently recognizes domestic resource mobilization. But with this attention to domestic resource mobilization, we shouldn’t lose sight of a critical point: collecting more taxes will only advance the SDGs if the revenues are spent efficiently.
Developing countries are collecting more taxes, but how is the money spent?
The good news is that developing countries are increasingly collecting more taxes domestically. Between 2002 and 2014, average tax ratios rose by 2.8 percent of GDP in sub-Saharan Africa and by 3.6 percent in the Western Hemisphere and emerging and developing Asia. IMF and World Bank analyses suggest substantial tax potential in these countries going forward through broadening their tax bases and improving compliance.
But even if taxes grow in the next 12 years at the same pace as in the previous 12, would they be sufficient to fund the infrastructure and social needs of developing countries? Definitely not! This means that policymakers must complement tax-enhancing efforts with other policy measures if they are to make progress toward achieving the SDGs. I argue that such efforts must be directed at improving the spending side of the budget.
Governments are a kind of producers, producing varied outputs by combining labor with different inputs. For instance, they hire teachers and doctors and buy books and medicines to produce education and health outputs, such as enhancing literacy and life expectancy for their citizens. On average, developing country governments (both low-income countries and emerging market economies) spent between 7 and 9 percent of GDP on education and health, and up to 8 percent of GDP on public investment, in 2015. Social sector spending is likely to rise with an expanding revenue base and growing GDP.
The question is whether developing country governments are undertaking this spending at the lowest possible cost, consistent with efficiency considerations. The answer is not really.
The evidence on inefficient spending
The estimates below illustrate the scope for resource savings and possible improvements in outcomes through better spending. (Developing countries are not alone in spending inefficiently; there are comparable estimates for advanced economies.)
Some countries (for example, in Africa) use between 25-35 percent more inputs in both the education and health sectors to produce outputs that are comparable to countries viewed as more efficient. In India, education and health spending in six states could be reduced by 50 percent or more without loss in output.
The bottom 25 percent of the most inefficient countries in a group of 80 countries studied could potentially gain up to five years in (health-adjusted) life expectancy by using their existing allocations as productively as the most efficient countries. By comparison, a 10 percent across-the-board increase in public health spending per capita in all countries would improve life expectancy by only two months. This shows that higher spending on its own cannot improve outcomes, unless undertaken efficiently.
Developing countries lose more than one-third of their public investment through inefficient spending. This is a pity because these countries are faced with vast infrastructure gaps. Inefficient spending implies a reduced effect of public investment on growth—the impact is estimated to be half as much as compared to countries where investment spending is efficient.
Energy subsidies are an inefficient way to provide income support to low-income households as most of their benefits accrue to better-off households. These subsidies are large, particularly when they are defined broadly. According to the IMF, energy subsidies amounted to $5.3 trillion (6.5 percent of global GDP) in 2015. They include the direct cost to the budget for supplying energy below costs, undercharging for the damage caused to the environment (e.g., pollution and congestion) by energy consumption, and revenue losses arising from low consumption taxes on petroleum products compared to other consumption goods. Removing these subsidies can generate 3.6 percent of GDP of additional revenue globally.
Room for resource savings
It appears that outlays of over 15 percent of GDP on education, health, and public investment are not well spent in developing countries. Assuming an average inefficiency of 20 percent—which is less than the estimates reported in studies—developing countries could generate resources equivalent to 3 percent of GDP by adopting efficiency-enhancing measures. This gain is likely to be of the same order as from domestic taxation in the next 12 years, assuming past trends continue. Further gains are possible through a rationalization of generalized subsidies on petroleum.
What kind of efficiency-enhancing measures could countries adopt? They will have to be country-specific, depending on spending patterns and prevailing institutions. The above studies found that poor governance, weak institutions, and a high share of wage payments in social sector spending are associated with inefficiency. A high share of wage outlays squeezes spending on books and teaching material in classes or medicines and other equipment in hospitals. When it comes to public investment, public financial management institutions, notably project appraisal, selection, and management, would need to be strengthened.
Moving forward with a focus on spending efficiency
There are two steps that countries and international institutions can take to ensure that policymakers don’t lose sight of spending in the budget, complementing efforts to collect more resources domestically.
Countries should periodically review their spending programs, either on their own or with assistance from external experts. Spending reviews help identify inefficiencies in ongoing programs and can guide policymakers in shifting expenditures from lower priority areas to higher priority ones. Such reviews have been carried out with success in a number of emerging market economies (e.g., Croatia, Romania, Slovenia, and the Slovak Republic).
Assistance from international institutions and donor countries should extend beyond strengthening tax systems to enhancing the efficiency of spending programs. Under the Addis Tax Initiative launched in July 2015, international institutions and donor countries committed to scale up assistance for building tax capacity of developing countries; how countries spend their revenues should be a central part of this support. Every project on revenue mobilization should have an expenditure rationalization component, which should not only assess the quality of existing programs but also discuss how additional taxes stemming from tax reforms will be used. By focusing on both sides of the budget, we can make faster progress on achieving the SDGs.
Let us all agree that there is no point in collecting more taxes domestically if they are used to finance inefficient programs.