Fiscal policy

Main relevant SDG targets:

9.1: Develop quality, reliable, sustainable and resilient infrastructure, including regional and transborder infrastructure, to support economic development and human well-being, with a focus on affordable and equitable access for all

9.4: By 2030, upgrade infrastructure and retrofit industries to make them sustainable, with increased resource-use efficiency and greater adoption of clean and environmentally sound technologies and industrial processes, with all countries taking action in accordance with their respective capabilities

10.1: By 2030, progressively achieve and sustain income growth of the bottom 40 per cent of the population at a rate higher than the national average

10.4: Adopt policies, especially fiscal, wage and social protection policies, and progressively achieve greater equality

12.7: Promote public procurement practices that are sustainable, in accordance with national policies and priorities

1. Integrating fiscal policy into a broader development strategy

Virtually all measures of public policy in LDCs aimed at influencing the speed and direction of structural transformation will have repercussions on the government budget.

One reason for the weakness of the developmental state and the insufficient provision of public services and infrastructure to support private productive activities in LDCs is the narrowness of fiscal space, i.e. the low level of public revenue as a result of narrow tax bases, deficiencies in tax collection and administration and losses due to illicit financial flows (LDCR 2016: ch.1 and ch.5). To some extent, fiscal space is itself a policy variable in the process of structural change. It depends, inter alia, on the ability of

the government to impose and collect taxes and on the repercussions of GDP growth on public revenues.

Public finances have both direct and indirect effects on demand and supply in an economy. The direct demand effects result from the current consumption of goods and services, as well as the infrastructure investments made by public entities. Direct supply effects result from the public provision of services to citizens and enterprises. Indirect demand effects result from the impact of taxation, social transfers and subsidies on income distribution and on the spending behaviour of citizens and firms, while indirect supply effects result from the productive use of public services and infrastructure by enterprises and agricultural producers.

Thus, fiscal policy is not only about budget management. By using fiscal instruments, governments influence the pace of productive capacity building and the direction of structural transformation. Of particular importance in this context is the influence of fiscal instruments on the investment behaviour of private entrepreneurs (o ch.IV.C).

Different types of public revenue, such as taxes and customs duties, and of public expenditure, such as various types of infrastructure, public services or subsidies have different effects on both the level and the structure of economic activity. Therefore, decision making, and budgetary and tax planning are inexorably linked with the design and implementation of a country’s development strategy.

2. Public revenue management

2.1 Functions and structure of public revenue

Public revenue collection must capture a share of national income that enables necessary and desirable public expenditure for the provision of infrastructure and public services.

At the same time, the composition of public revenue and its variation over time are key instruments to shape economic activity on both the demand and the supply side. They also play an influential role in income distribution.

The tax base in LDCs is very narrow, due in part to low income levels and the large size of the informal sector (LDCR 2014: ch.6). In most LDCs, public finances have traditionally been highly dependent on revenue from customs duties. While trade liberalization is an element of policies that support structural transformation (o ch.VI.B), the reduction of tariff barriers implies a further narrowing of fiscal space, which needs to be compensated for by higher revenues from other income sources. The same effect results from tariff exemptions for certain imports that are often granted as an incentive for export-oriented production (LDCR 2009: ch.2). Further large tariff cuts should be implemented only after alternatives sources of public revenue have been identified.

The structure of personal income taxation and specific indirect taxes on certain types of consumption influence the pattern of domestic demand with possible repercussions for the structure of domestic production and the trade balance. The design of corporate taxation, which can serve as a major policy instrument in support of structural transformation, is even more important for shaping the dynamics of structural change.

2.2 Using tax privileges to influence entrepreneurial behaviour

Corporate taxation can be geared towards strengthening the link between corporate profits and investment at the firm level, e.g. allowing specific systems of fiscally-relevant depreciation allowances or loss allocation, or the preferential treatment of reinvested profits (o ch.IV.C). Tax holidays for foreign investors are a possible instrument to attract foreign direct investment (FDI), as are direct tax breaks for exporters to stimulate export-oriented production and bolster the international competitiveness of local producers (o ch.VI.C).

Fiscal incentives in the form of tax or customs privileges can initially lead to a significant reduction in the total tax yield, but if applied successfully, the resulting income gains can subsequently generate an increase in public revenue that compensates for and may even exceed, much of the initial fiscal cost (DTIS Ethiopia). Direct income and corporate taxes tend to rise faster as the economy grows, provided that such taxes are effectively collected and the overall pattern of tax rates is progressive. It is therefore essential that the influence of interest groups, including foreign investors, and politically connected domestic companies and individuals, do not gain the upper hand in corporate tax governance.

In terms of attracting FDI, the effect of such tax incentives has often been disappointing because other determinants of FDI, such as attractive labour costs or a large raw material base, are of similar or even greater importance (EDAR 2014: ch.5; DTIS Ethiopia). Therefore, although tax concessions can be justified in some cases, many LDCs could benefit from a thorough review of the concessions they have granted and the costs and benefits that these generated.

2.3 Strengthening public revenues

Measures that may be beneficial for strengthening and diversifying public revenues include increased taxation of high incomes and incomes from capital rents and speculative activities; increased taxation of wealth, especially higher value-urban properties;

introducing consumption taxes on luxury goods and excise duties on alcohol, tobacco products and vehicles; broadening value-added tax (VAT) on non-essential items; and reducing tax holidays and exemptions for corporations and expatriates (LDCR 2009:

ch.2). Incorporating more informal businesses into the formal sector is another crucial

part of the strategy to increase government revenue (LDCR 2014: ch.6) (m ch.I.C; o ch.III.E).

Where appropriate, as part of a broader strategy for structural transformation, higher import tariffs (within World Trade Organization (WTO) obligations and existing trade agreements) could provide additional revenues (LDCR 2014: ch.6). Authorities in LDCs should also explore opportunities for developing non-tax revenues, such as royalties, user fees or licenses, which potentially can serve as a major source of public revenue.

This is a particularly relevant consideration for LDCs with important extractive industries (o ch.VI.B). In several countries there appears to be scope for increasing public revenue from this source (LDCR 2014: ch.6).⁷ Royalties should be determined as a proportion of company sales, given the problems associated with profit-based taxation resulting from creative accounting practices on the part of — typically foreign — mining companies (UNCTAD 2009: ch.III; LDCR 2010: ch.6).

2.4 Improving tax collection

It is estimated that some countries could double their tax revenue by improving tax collection alone. Tax collection can be enhanced when the tax system is perceived to be fair, not overly complicated and when taxpayers can be assured that public revenues are used efficiently (UNCTAD 2009: ch.III).⁸ Related measures include enacting rules on tax avoidance and enlarging the capacity of tax collecting institutions by increasing the number of staff in tax administrations and improving their skills through training. Tax authorities can further improve their effectiveness through the use of better equipment for information management and the implementation of controls on tax declarations.

This should be complemented with measures to encourage voluntary compliance and regular risk-based audits of firms and corporations. Tax fraud should also be severely penalized (UNCTAD 2009: ch.III; LDCR 2016: ch.2).

In many countries, efforts to raise public revenue must also target the prevention of illicit cross-border financial flows (UNCTAD 2009: ch.IV).⁹ These occur mainly in connection with tax evasion related to commercial activities (more than 60 per cent of illicit flows), as well as with criminal activities and corruption. Illicit flows are facilitated by abusive transfers and trade mispricing, the misinvoicing of services and intangibles, and unequal contracts. They are highest in the extractive industries (EDAR 2016: ch.4). At the national level, it is important to strengthen the relevant regulatory frameworks and enforcement mechanisms that severe punishments for intentionally providing incorrect taxation-relevant information about commercial and trade activities. However, since these flows are international in nature, preventing them requires international commitment and more effective cooperation in tax matters. LDCs require multilateral support in building their institutional capacities to deal with such flows (EDAR 2016: ch.4) (o ch.VII.D).

Finally, it must be acknowledged that any improvements in tax collection through the reform of public financial management systems can be counteracted by corruption in tax collecting agencies. In this regard, combatting corruption and introducing or strengthening control mechanisms is essential (UNCTAD 2009: ch.III; LDCR 2016: ch.2).

3. Public expenditure for the expansion of productive capacities

On the expenditure side, the challenges are to identify the priorities and optimal sequencing for the allocation of public finances and to find an appropriate balance among different targets. The social pillar of sustainable development — as reflected in several SDGs — calls for considerable increases in public expenditure to improve public services in health care, general education and social protection. From the perspective of accelerating economic development, increased spending on infrastructure and public support services for productive activities is indispensable.

Even within these categories, spending cannot be increased at the same time for all needs and purposes. In current spending, priority must be given to mitigating the symptoms of extreme poverty. Capital expenditure, which is vital from the perspective of structural transformation, must focus on infrastructure investment in those areas where the constraints on the expansion of productive capacities are most strongly felt (m ch.I.C; o ch.IV.C). Moreover, public procurement can play a key role in the expansion and upgrading of domestic industries and services. Giving public procurement priority to locally produced inputs can make a significant contribution to the development of sectors that are of strategic importance for structural transformation (DTIS Ethiopia) (o ch.IV.B). Finally, different forms of subsidies can be instrumental for building productive capacities and accelerating structural transformation by influencing the cost structure of producers or enabling access to essential inputs.

4. Budgetary discipline and public debt financing

Budgetary discipline is the basis for sustainable public finances and there can be no doubt about the need to keep public sector borrowing and debt accumulation in check. Some tax and social expenditure policies — for example progressive taxation, welfare and social protection policies — can act as automatic stabilizers. In commodity-dependent countries, stabilization funds or variable export taxes can also be important for macroeconomic stabilization.

It is therefore important to consider a fiscal deficit in its context. It is not only the size of the public sector deficit (measured, for instance, as a percentage of gross domestic product (GDP) that matters for its sustainability and the soundness of budgetary

management, but also its origin and the way in which it is financed. A deficit that arises from a temporary slowdown of growth has a stabilizing effect and is, therefore, less problematic than a high fiscal deficit during a period of fast growth. Deficit targets should therefore allow for flexibility to enact countercyclical policies during economic downturns, particularly in countries heavily dependent on commodity exports (LDCR 2014: ch.6). Similarly, a deficit that arises from excessive current spending on public consumption is of a quite different nature than a deficit that is the result of increased spending on infrastructure investment in support of productive activities. The first will soon become unsustainable, whereas the second, similar to private capital investments, can be expected to generate a future return in the form of higher tax revenues (LDCR 2009: ch.2) (o VII.D). As a general rule, over the medium term, public sector deficits as a share of GDP should not exceed the GDP growth rate. In absolute terms, they should not surpass the level of public investment expenditure on (LDCR 2014: ch.6).

Public sector deficits in LDCs are financed in large part by external borrowing. Therefore, maintaining external debt sustainability is a challenge for LDCs in their efforts to finance national development strategies and in the context of the 2030 Agenda for Sustainable Development. Currency and maturity mismatches must be avoided. Furthermore, debt sustainability analysis should also reflect domestic debt exposure. Again, external debt sustainability does not only depend on the size and structure of the debt, but also, inter alia, on whether the deficit financed is the result of expenditure for public infrastructure investments or is the product of current spending. Fiscal authorities should select debt-financed investment projects primarily considering the contribution they could make to strengthening productive capacities that will contribute to higher fiscal revenue in the future (EDAR 2016: ch.5) (o ch.VII.B).