Fiscal capacity

Fiscal capacity is the ability of the state to extract revenues to provide public goods and carry out other functions of the state, given an administrative, fiscal accounting structure.[1] In economics and political science, fiscal capacity may be referred to as tax capacity or 'the power to tax,' as taxes are a main source of public revenues. Nonetheless, though tax revenue is essential to fiscal capacity, taxes may not be the government's only source of revenue. Another source of revenue is foreign aid.

In addition to the amount of public revenue the state extracts, fiscal capacity is the state's investment in "state structures -- including monitoring, administration, and compliance through such things as training tax inspectors and running the revenue service efficiently".[2] When investment in these administrative or bureaucratic fiscal structures are specific to the state's power to extract resources, fiscal capacity is moreover related to a larger concept of state capacity. Finally, given that public goods funded by fiscal capacity include infrastructure development, health, education, military and social insurance, a state's fiscal capacity is essential to its economic growth, development, and state-building.[3][4]

Definitions and Patterns

Definitions

A frequent measure of fiscal capacity is the proportion of GDP generated by tax revenue.[2][3] However, fiscal capacity is measured not only by the level of tax revenue a state is able to raise, but by the quality and size of the tax administration itself, as well as the administration's ability to enforce tax policies.

Patterns

Tax policy shapes a state's fiscal capacity, fiscal capacity describes the government's ability to provide public goods, and both the strength and the structure of fiscal capacity varies across states. Evidenced by the patterns, the discussion regarding fiscal capacity very much revolves around the comparison of tax structures between poor and rich, developing and developed countries, finding a solution for weak fiscal capacity.

Richer and more developed countries have larger, stronger tax administrations and raise more money through tax revenue than poorer, developing countries. As is such, the more revenue a country raises, the greater its fiscal capacity is.[2]

In addition to generating increased revenue levels, rich countries tend to rely more on the personal income tax and consumption taxes, whereas poorer countries rely on less efficient tax types, such as corporate income taxes, tariffs, and seignorage.[2] Yet, public finance literature frequently emphasizes the revenue-maximizing potential and efficiency of income and value-added taxes and the lack of that with tariffs or seignorage. Social science literature on fiscal capacity aims to solve this puzzle.[1][3][5] Nonetheless, better tax structures are correlated to greater fiscal capacity because they encourage more efficient collection, deter tax evasion, and impose fewer economic efficiency costs. States with high fiscal capacity thus raise revenue "in a way that does not impose large distortions in relative prices", namely through the use of more efficient tax types.[4][6]

Accordingly, different tax structures reflect preferences for private versus public goods and redistribution. Because countries differ in their investments on the military, public education, infrastructure (etc.), tax structure and fiscal capacity can reflect the the different social, political and economic identities of each state.[3] Accordingly, poor states or developing countries with low fiscal capacity are more likely to be unable to provide public goods.[4]

Moreover, fiscal capacity reflects the political, social and economic conditions of a state effect. In particular, the presence of a large informal sector is correlated with weaker fiscal capacity. In 2000, Friedrich Schneider and Dominik Enste estimated the 2002 size of the informal sector for a variety of countries. They find that "the informal economy on average is only about 15% of GDP among OECD countries, and thus small enough that it should not be a driving force in the choice of tax structure. However, among developing countries, the median size of the informal economy they report is 37% of GDP, ranging from 13% in Hong Kong and Singapore to 71% in Thailand and 76% in Nigeria."[3][7]

Fiscal Capacity in Practice

Administration

A state's fiscal capacity is determined twofold; the amount of revenue that tax administration is able to raise, and the amount of resources that go into producing a tax administration.

Fiscal capacity and tax structure depends immensely on the strength and capabilities of the administration itself. A revenue service acts as a monitoring body that aims to enforce compliance and deter tax evasion. As is such, different tax policies and structures may indicate the different ways countries deal with tax evasion in accordance to the different social and political situations that take place in each state. For instance, the Internal Revenue Service is an example of a strong tax administration, as it has a large number of employees and can therefore more easily monitor each individual in the US. On the other hand, where poorer countries lack tax personnel, an inefficient narrow-based tax such as border tax is much easier to monitor. [source needed] While tariffs are less efficient and impost greater deadweight loss on an economy, the recommended income taxes are much easier to evade.[2] In practice, generating large tax yields and low incidences are complicated by issues with tax evasion. Thus, a tax administration's goal is to therefore not simply maximize revenue and economic efficiency, but to monitor the peoples of a state and facilitate tax compliance. Furthermore, a functioning bureaucracy effectively provides public goods and "facilitate[s] trust between government officials and citizenry", where "effective provision" means that "public goods are delivered in a cost-effective and non-corrupt manner" and in a way that "does not generate large deadweight losses."[4][8]

In "Administrative Dimensions of Tax Reform", Richard Bird explains that the strength of a tax administration is determined by the number of trained personnel, adequate infrastructure (including technology and modern computer systems), as well as a functioning "information system". This information system determines the tax base, as well as identifies, classifies and monitors taxpayers. It further facilitates the collection of information from each individual, third parties, and other sources from within the tax administration. In addition, there should also exist a system of rewards and penalties to enforce tax compliance. And finally, there must be a system to both redress grievances and complaints should the system fail, and identify and address mistakes with the tax system before they occur. Tax administrations are complex and require a vast amount of resources that not all states can afford.[9]

Nonetheless, compliance does not only depend on the effectivity of the tax administration, but the social and political environment of the state as well.[9]

Tax Structure

Optimal taxation theory states that the ideal tax structure maximizes efficiency and consists of "no tariffs, no taxes on capital income, uniform taxes on consumption, and deflation."[3][10] Generally, taxes considered inefficient are narrow-based taxes such as tariffs and seignorage, and efficient taxes are broad-based taxes such as income tax, value-added tax, and the corporation tax. For more on tax structure and efficiency, see Tax. Developed countries and states with strong fiscal capacity tend to rely on these efficient, broad-based taxes, whereas the reverse holds true for developing countries.

However, taxes traditionally considered inefficient may better achieve fiscal goals in the presence of factors frequently found in developing countries; these factors—informal economies, low tax-morale, low-quality governance, and insufficient resources for large, administrative tax structures like that of the US's Internal Revenue Service—are why developing countries cannot simply raise taxes to attain a higher GDP or fund more public goods.[3] For instance, when large informal economies exist and taxes are raised, people are more inclined to shift out of the formal sector into the informal sector of the economy. Especially in countries with low tax morale, as a state raises taxes, tax evasion increases and fiscal capacity becomes weaker.[5] As a solution, less efficient but more easily monitored taxes such as border taxes are put into place, . Moreover, because tariffs are easier to collect, they require "less institutionalized structures of compliance".[2] Emran and Stiglitz (2005) for instance, also argue that "tariffs may provide a less distorting source of tax revenue" given the shit of formal to informal sectors.[3][11] In comparison, an individual income-tax or a consumption tax is much more difficult to monitor and necessitates a strong tax administration.

All in all, states with low fiscal capacity tend to use inefficient tax types when large informal economies are present, and if they do not have the administrative capacity to support the collection of efficient taxes.

Origins

This section explains different theories on the origins of fiscal capacity. Specifically, political historians frequently highlight War-making as a catalyst for state-making, and more recent literature on fiscal capacity further emphasizes the role of elites.

War

Political historians, specifically Charles Tilly, view war as the incentivizing mechanism for states to invest in extractive structures and likewise, fiscal capacity. Tilly theorizes that since before the modern state, individuals have displayed powers of "extraction", when individuals plundered each other's villages to extract resources. He defines "Extraction" as one of four main activities that define a state, and is "the means of carrying out the first three activities -- war making, state making, and protection."[12] Tilly explains that "Extraction" takes place at different levels of the state—from the beginning of civilization to the modern tax system. A parallel can be drawn to Marcus Olson's theory on roving and stationary bandits, where the start of civilization stems from the incentive of a selfish 'stationary bandit' to capture and extract from a village over an extended period of time.

Since Tilly's monumental theories on war and state-building, his theories have since been reinforced by political economist studying the connections between military revolutions and state capacity. For instance, Besley & Persson extend Tilly's theories to confirm a negative correlation between countries historically associated with war and trade taxes; in doing so, Besley & Persson explain that war-making is associated with a more efficient tax structure and likewise stronger fiscal capacity.[2]

References

  1. 1 2 Kaldor, Nicholas (1963-03-01). "Taxation for Economic Development". The Journal of Modern African Studies 1 (01): 7–23. doi:10.1017/S0022278X00000689. ISSN 1469-7777.
  2. 1 2 3 4 5 6 7 Besley, Timothy J.; Persson, Torsten (January 2013). "Taxation and Development" (PDF). CEPR Discussion Paper No. DP9307. Retrieved Mar 6, 2016.
  3. 1 2 3 4 5 6 7 8 Gordon, Roger; Li, Wei (2009-08-01). "Tax structures in developing countries: Many puzzles and a possible explanation". Journal of Public Economics 93 (7–8): 855–866. doi:10.1016/j.jpubeco.2009.04.001.
  4. 1 2 3 4 Johnson, Noel D.; Koyama, Mark (2015). "States and Economic Growth: Capacity and Constraints" (PDF). George Mason University WORKING PAPER. Retrieved March 6, 2016.
  5. 1 2 Bird, Richard (July 2013). "Taxation and Development: What have we learned from fifty years of research?" (PDF). Institute of Development Studies Working Paper 2013 (427). ISSN 1353-6141.
  6. ↑ Lindert, Peter H. (2004). Growing Public: Social Spending and Economic Growth since the Eighteenth Century. Cambridge University Press. ISBN 9780521529167.
  7. ↑ Schneider, Friedrich; Enste, Dominik H. "Shadow Economies: Size, Causes, and Consequences". Journal of Economic Literature 38 (1): 77–114. doi:10.1257/jel.38.1.77.
  8. ↑ Levi, Margaret (1989). Of Rule and Revenue. University of California Press. ISBN 978-0520067509.
  9. 1 2 Bird, Richard M. (March 2004). "Administrative Dimensions of Tax Reform". International Bureau of Fiscal Documentation Asia-Pacific Tax Bulletin.
  10. ↑ Diamond, Peter; Saez, Emmanuel. "The Case for a Progressive Tax: From Basic Research to Policy Recommendation". Journal of Economic Perspectives 25 (4): 165–190. doi:10.1257/jep.25.4.165.
  11. ↑ Emran, M. Shahe; Stiglitz, Joseph E. (2005-04-01). "On selective indirect tax reform in developing countries". Journal of Public Economics. Cornell - ISPE Conference on Public Finance and Development 89 (4): 599–623. doi:10.1016/j.jpubeco.2004.04.007.
  12. ↑ Tilly, Charles (1985). War Making and State Making as Organized Crime. Cambridge University Press. pp. 169–191. ISBN 9780511628283.
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