MINISTERIAL MEETING

ON ENHANCING THE MOBILIZATION OF FINANCIAL RESOURCES

FOR LEAST-DEVELOPED COUNTRIES’ DEVELOPMENT
LISBON 2-3 OCTOBER 2010
Background Paper
EFFECTIVE MOBILIZATION OF DOMESTIC RESOURCES BY LDCS
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Introduction
1. Domestic savings have a critical role to play in financing development. They are
needed to provide resources for investment, boost financial market development, and
stimulate economic growth. Yet, most LDCs have difficulties mobilizing adequate
domestic resources to meet their investment needs. This is mainly due to the
predominance of subsistence activities which barely generate enough resources to
meet basic consumption needs and the overall high levels of poverty, with extreme
poverty exceeding 50 per cent on average in LDCs.
2. Resources for investment in most LDCs are predominantly foreign especially
ODA, FDI and remittances. However, the high dependence of LDCs on external
resources limits their policy space and creates some dependency. Their eeconomic
vulnerability is further exacerbated by indebtedness, which remains a challenge despite
major write-offs in the recent past, especially since global interest rates are expected to
increase in upcoming years. In a similar vein, many LDCs run large deficits in the
current and trade accounts, financed by official grants and loans. Even a small reversal
in external capital flows may therefore cause domestic contraction. Mobilizing domestic
resources will help reduce vulnerability arising from dependence on fragile external
income. Domestic resource mobilization provides the only viable long-term financing
basis for development expenditures.
3. The BPoA recognizes that the most important financing of development comes
from domestic resources. Specifically it calls for the promotion and enhancement of
effective measures, including fiscal and financial sector reforms for better domestic
resource mobilization (Paragraph 29 (l)). The importance of domestic resource
mobilisation for example for infrastructure development is stressed at various occasions
in the BPoA but there are little concrete measures and no explicit goals on this issue.
There is only the general goal to increase the ratio of investment to GDP to 25 per cent
per annum which could not be reached so far despite considerable efforts. As there has
been also very limited progress in this important area there is a need to review the
factors behind the slow resource mobilisation and build on best practices.
Recent developments in domestic resource mobilisation
Government revenue
4. The ability to generate domestic revenue is one of the core roles of governments
and a precondition to establish a developmental state, which actively designs and
implements development strategies. On average, LDCs’ level of tax revenue per GDP
is two to three times lower than in OECD countries and less than half of the average for
upper-middle income countries. Studies on the optimal level of taxation for development
vary, but mostly suggest that revenues in the vicinity of 25 per cent of GDP are
desirable. It is therefore safe to say that at only around 10 per cent of GDP on average,
LDCs are far short of collecting adequate budgetary resources to provide much needed
public investment and services.
5. There are also considerable differences among LDCs, with five countries even
reporting rates below 10 per cent and another 9 countries showing rates between 10
and 15 per cent in recent years, out of 18 countries for which data exist for 2002 to
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2008 (see Appendix). The low level of taxation would appear to suggest that LDCs
have considerable room for improvement in this area.
6. Some exceptions notwithstanding, LDCs as a group have not seen a significant
rise in tax revenues per GDP in recent decades. Where such a rise has occurred, it was
mainly due to an increase in resource-related taxes, sometimes with the effect of
crowding out more traditional sources of tax revenue.
7. Many commodity-exporting LDCs have seen sizable increases in revenues as
the prices of these commodities rose over the past years. However, revenue from
taxing extractive industries is even more volatile and pro-cyclical than tax revenues in
general, so it is crucial to administer the proceeds well and account for this volatility
when designing resource tax policy. Besides being volatile, LDCs also seem to be
under-taxing extractive industries, foregoing significant and easily accessible revenue
as a result. Part of the perilous nature of taxing extractive industries is that it allows
governments to shy away from more politically demanding taxes such as corporate and
personal income taxes. Indeed studies have shown that higher income from resource
taxes was regularly accompanied by stagnating or even declining revenues from other
tax sources for several African LDCs.
8. Revenues from trade taxes have declined in recent years but account still for a
significantly higher share in tax revenue than in other developing countries. Further
trade liberalization suggests a continuation of the declining trend in the medium term,
albeit with a prospect of increased revenues if trade volumes expand as a result of
liberalization in the long run. Whether the net effect will be positive or negative
eventually, the immediate consequence of this development is that lost revenues have
to be replaced in the short run.
9. A number of LDCs have made attempts to compensate for the shortfall in trade
taxes by establishing or increasing value-added taxes VAT. However in the context of
LDCs VAT is not likely to be as efficient as in developing countries, in part because of
the need for extensive bookkeeping and the prevalence of a large informal sector.
10. The financial and economic crisis affected tax revenues mainly negatively. While
public spending remained at relatively high levels, government revenue decreased,
reflecting shortfalls in customs collection due to weakened imports and lower tax
collection, in the context of the tapering off in economic activity. Thus, tax revenues
were well below the targets set by many countries and fiscal deficits increased. This
countercyclical policy was mainly possible to to increased macroeconomic stabilisation
over the past decade.
11. Large parts of the economy in LDCs are informal, and by definition the “informal
economy” comprises workers and companies operating outside the reach of the law or
public administration. Thus a large informal sector is a major obstacle to broadening the
tax base and collecting direct taxes. However, better integrating them into the tax
process is important for two reasons. First, these usually small enterprises and income
earners are sources for additional revenue that have not been tapped so far. However,
tax authorities have to be cautious in comparing the administrative costs to the benefits
in revenue, and make sure that presumptive taxes, for example, are imposed only
where sensible revenues are to be expected and economic distortions are not too big.
Second and maybe more important, sensible taxation turns small enterprises into
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stakeholders of a developmental state designing and implementing industrial policies
for structural transformation.
12. Domestic resource mobilization is critical to reducing LDCs’ vulnerability to
external shocks. For instance, many LDCs are highly reliant on exporting a small set of
commodities and suffer from large swings in revenues as the prices of these
commodities fluctuate on world markets. While taxation does not sufficiently address
this lack of economic diversity, it may help mitigate its consequences in two ways. On
the one hand, a better design of resource taxes would allow governments to generate
adequate revenues when prices are high. Saving and investing some of these proceeds
would then enable LDCs to reduce macroeconomic instability by smoothening the path
of government expenditure. On the other hand, a more balanced tax mix that draws on
a wider range of contributors may reduce dependence on resource taxes altogether
and could help stabilize public revenues in LDCs.
13. For raising revenues not only tax rates are important but the revenue
administration is playing a crucial role. There has been substantial progress in the tax
administration of LDCs. The time needed to prepare and pay taxes per year is, on
average, not much higher in LDCs (258 hours) than in OECD countries (216 hours)
according to World Bank statistics.
14. Some LDCs, for instance Rwanda, have implemented modern administration
structures for their tax authorities, replacing geographical organization by functional
departments that cover different tax segments or tax payer groups or specialize in
certain aspects of the taxation process such as analysis, audit or appeals.
15. Likewise the government of Bangladesh has taken measures to increase
domestic resources through better compliance, collecting arrears, and extending VAT.
It plans to introduce full automation of tax and customs administration, shorten the list
of tax exemptions, expand the existing tax base, and improve and strengthen the
monitoring of tax collection, among others.
16. Profound improvements in generating domestic revenues will not come quickly.
Instead, the scope of several key underlying problems such as limited tax
administration capacity, narrow tax bases, and attitudes towards taxation suggests that
in order to bring about such change, many years of sustained efforts will be required on
the part of governments and citizens alike. So donors should not see domestic resource
mobilization as a substitute for urgently needed increases in ODA.
17. In the long run, however, LDCs should see taxation as an opportunity to shift
accountability back from donors to their own citizens, creating a more stable and more
legitimate state in the process. Indeed if LDCs are to reassert ownership of their
development paths – ultimately a necessity for successful development – they need to
increasingly rely on domestic rather than external public resources. LDCs should work
towards a fair, simple, and efficient tax system to allow for a better provision of
government services, which in turn would make tax payers more compliant and
governments more accountable.
18. Tax preferences granted to certain groups of tax payers can have many reasons.
Sometimes they are plainly political, but tax incentives for foreign investors or domestic
businesses are not negative per se. However, tax exemptions tend to make tax
systems more complex, undermine the tax base, reduce fiscal legitimacy, and create
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opportunities for corruption. Granting preferential tax treatment should thus be the
exception, not the rule.
19. Relying more on income tax and exemptions on basic consumer items would
enable more redistribution of resources. But where administrative capacity is weak,
personal income tax is less progressive than expected. Firstly, only wages, mostly
earned in large private firms and in the public sector, are taxed. Secondly, personal
income earned on capital is typically not taxed. Capital, real estate income and other
revenues of high earners in the informal sector are thus outside the reach of tax
administration.
20. The ability to collect and administer taxes and to detect and prosecute tax fraud
requires considerable administrative capacity, which many LDCs lack. At the same
time, inefficient bureaucracies make paying taxes costly and often deter smaller
potential tax payers such as small and medium enterprises from contributing altogether.
Combating corruption
21. Combating corruption is crucial for increasing the effectiveness and transparency
of government revenue and expenditure. To date, 32 of 49 least developed countries
are States parties to the United Nations Convention against Corruption (UNCAC), and 6
are signatories. Haiti, Lao Peoples Democratic Republic and Timor Leste have ratified
the Convention in 2009. Of the least developed countries who are States parties, 14
completed the original UNCAC self-assessment checklist, which considered 15 Articles
of the Convention.
22. The Extractive Industries Transparency Initiative (EITI), which has been
endorsed by the General Assembly in 2008, is also gaining momentum in least
developed countries. 15 least developed countries have been candidate countries as of
April 2010, having completed the sign-up phase and working towards full
implementation of all EITI principles and criteria, which will make revenues from
extractive industries more transparent.
Private savings and investment
23. In addition to public investment financed mainly through taxes and ODA private
savings can also increase private domestic investment in LDCs. However, household
savings are generally low due to the high poverty rates. Furthermore savings are often
held in the form of assets like gold. In addition, domestic capital markets which would
channel savings into productive investment remain underdeveloped in most LDCs.
Ttraditional banks, with their high fixed costs, are poorly placed to cater to the majority
of the population, as they remain concentrated in urban areas with high minimum
deposit requirements putting them out of reach for most. Deepening domestic finacial
systems can also enable households to smooth consumption and investment more
efficiently thus reducing risks.
24. As experience from more advanced countries shows capital markets can play an
important role in the mobilization of domestic resources even at low average income
levels. By protecting investors, ensuring fair, efficient and transparent markets and
reducing systemic risk, efficient capital market regulation increases operators’
confidence and attracts investors.
25. By protecting investors, ensuring fair, efficient and transparent markets and
reducing systemic risk, efficient capital market regulation increases operators’
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confidence and attracts investors. The development and expansion of capital markets
in LDCs is constrained by factors such as limited market size and capacity, lack of
trained human capital, market fragmentation, shortage of equity capital, information
inefficiency, inefficient regulatory regimes and lack of investor confidence in stock
exchanges.
26. Banks in LDCs tend to hold large amounts of excess liquidity, charge high
lending rates of interest, and prefer short-term, risk free government securities.
Moreover, the spread between deposit and lending rates of interest has remained wide.
Risk is one explanation for such wide spreads. The market power exercised by the
small number of large and often foreign-owned banks that dominate the financial sector
in LDCs is another. Unfortunately, as long as such high real rates of interest prevail and
interest rate spreads remain wide, there is little prospect for accelerated capital
accumulation, which has to be the driving force for long-term growth and development.
27. Development banks, which have been abolished in many LDCs, were often
effective at performing the essential function of mobilizing and allocating long-term
investment-focused development finance. Domestic commercial banks have been
unwilling to undertake this function, particularly in the wake of financial liberalization.
28. Micro-finance institutions also have a role to play in the mobilization and
allocation of domestic resources. The emergence of micro-finance institutions in a
number of LDCs in the last decade has created opportunities for smallholder farmers in
rural areas and small businesses and households in urban areas to access credit for
business development and employment generation. Strengthening the capacity and
operational outreach of such institutions could accelerate the pace of financial sector
development as well as poverty reduction by reducing the number of credit-constrained
individuals and entrepreneurs.
29. However, only a few African countries have an appropriate legal provision and
regulatory framework that enable micro-finance institutions to function smoothly. Thus,
experience sharing and dissemination of good practices on micro-finance within the
continent could significantly improve the mobilization of savings and its transmission
into investment.
Capital Flight
30. Despite low savings rates many LDCs especially in Africa continue to experience
massive capital flight, some financed by borrowed funds. Indeed, empirical evidence
suggests quite ironically that Sub-Saharan Africa is a “net creditor” to the rest of the
world—in the sense that the private assets held abroad by Africans exceed the
continent’s liabilities to the rest of the world. This capital flight, which is very difficult to
measure as it is partly illicit, deprives LDCs of a sizable portion of the resources they
need for development financing. Some estimates indicate that capital flight exceeds the
stock of external debt in a number of LDCs. It also undermines domestic investment
and thus reduces long-term growth.
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Policy recommendations
Actions by LDCs
31. Tax revenues should not be seen as an alternative to foreign aid, but as a
component of government revenues that grows as the country develops. One of the
development dividends of effective tax systems is greater ownership of the
development process, whereby the government shapes an environment that is more
conducive to foreign and domestic private investment, sustainable use of debt and
effective foreign aid. The challenge is therefore for LDCs and their partners to reverse
the vicious circle of aid dependence shifting government accountability away from
citizens towards donors, and trigger a virtuous circle of aid becoming redundant by
supporting public resource mobilisation.
32. The most effective way of increasing public revenue is through policies that
increase the tax-base through sustained economic growth. Efficient tax collection also
strengthens public resource mobilization without over-taxing the economy. Any
increases in taxation should ideally be growth-neutral, without harming the already
weak private sector in many LDCs.
33. In designing tax policy, LDCs should aim to administer a broader range of taxes
in order to minimize economic distortions by equalizing marginal rates, increase
revenues, and enhance fiscal legitimacy. A wide tax base is more stable because it
relies on a diversified set of taxes, with a mild burden on each type of taxpayer and
each type of economic activity. A wide base engages a bigger range of stakeholders in
the national political process.
34. Specifically domestic indirect taxes need to be increased at a faster rate taking
into account concerns about distribution. Reducing VAT exemptions could contribute to
this goal. Raising VAT rates on luxury consumption items would help to augment
revenues and to enhance the equity of the tax structure. Such a change in policy would
also help to move some of the tax burden onto higher-income households that can
better afford to pay such rates.
35. An area of tax policy that has been neglected in LDCs is property taxes, which
often finance local Government. Such taxes mainly cover urban areas, where most of
the rich and the middle class are concentrated. Strengthening property taxes would
help make the general tax structure more progressive. Property taxes can also help to
boost domestic production, if they are used to finance the urban infrastructure on which
many countries’ manufactured export sectors rely.
36. Short-term tax policy options in most LDCs are constrained by the tax
administration capacity. In particular, there are fewer redistributive tax policies available
than in industrialized countries. Therefore, upgrading tax administration is a prerequisite
to reducing income inequality through progressive taxation.
37. Effectiveness in tax administration also requires that tax authorities are endowed
with greater powers of intervention to follow up and sanction tax evasion, for instance
by granting them more autonomy.
38. The relationship between tax payers and authorities needs to be improved. Tax
payers should be seen and treated as stakeholders rather than suspects, and public
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education campaigns can enhance understanding of the significance of taxation in the
wider population.
39. Implementing advanced IT systems will help boost analytical capacities of tax
administrations as well as making it easier to pay taxes through e-filing. Some
developing countries in Asia and Latin America have successfully embraced
information technology for this purpose and LDCs should follow their lead where
appropriate.
40. Improvement of capital markets is most urgent in the following areas: improving
access to financial services, both for potential savers and potential borrowers;
expanding the portfolio of savings and investment products available, and improving
information systems, which can help reduce the risk and uncertainty of lending and
investing, and help make better informed decisions about what the most productive use
for financial resources might be.
41. Expanding the provision of micro-savings, micro-insurance, venture capital and
long term financing would help provide the products best suited for the needs of savers
and investors in LDCs. Especially the re-establishment of development banks, rural and
agricultural banks and other institutions which fill the gaps in service provision needs to
be pursued to foster private investment. In addition to extending micro credit the
increasing use of technological tools, such as mobile phone banking could reduce costs
for financial services and increase access.
42. To increase also private savings capital markets need to be strengthened
through improved regulation. One way to increase the viability of capital markets is to
promote regional equity markets, especially by drawing on existing economic regional
integration. Encouraging illicit capital flow repatriation is another identifiable source for
increasing financial resources in developing countries.
43. It is important for Governments to institute some forms of management of the
capital account in order to safeguard the resources for development, including the
reduction of capital flight.
44. While some degree of macroeconomic stabilisation is beneficiall for long-term
investment and growth very low inflation rates should not always be the sole aim of
monetary policies. LDCs should also aim at ensuring moderately low real rates of
interest and enhanced supply of credit to stimulate private investment.
Actions by development partners/international community
45. Development partners should support LDCs in their efforts to raise domestic
resources through revenue generation and capital market developments. Support is
especially needed in the area of capacity building. Thus it is important to try to direct
ODA more towards building the domestic capacities of LDCs to mobilize domestic
sources of development finance. This implies much greater emphasis on mobilizing
domestic savings.
46. ODA could play a pivotal role in increasing domestic investment. If it is allocated
to key economic infrastructures with large spillovers, ODA may crowd in additional
investment and trigger large supply responses. In turn, this would spur income growth,
thereby strengthening the capacity of financial institutions to mobilize domestic savings.
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ODA could also directly and indirectly strengthenthe revenue mobilizing capacities of
LDCs.
47. To reverse and prevent capital flight a more transparent international financial
system and concrete measures to repatriate LDC assets from abroad are needed.
Sources
IMF (2010) Reaching the MDGs – Macroeconomic prospects & Challenges in Low-
Income Countries
UNECA (2010), Economic Report on Africa 2010, Addis Ababa
UNCTAD (2009), LDC Report 2009, New York and Geneva
OECD African Economic Outlook 2007, Paris
OECD African Economic Outlook 2010, Paris
UN (2005) Millennium Project
World Bank (2009), Statistical Database