Could tax reform bridge the development finance gap in fragile states?

A man collects tax at the livestock section of a market in Oronia, Ethiopia. Improving tax administration and collection in fragile states like Ethiopia is a sustainable development finance alternative. Photo by: Eileen Delhi / CC BY-NC-SA

Donor countries have recently re-prioritized fragile states after decreases in spending, but the international development community must identify alternative sources of development funding if these countries are to make progress toward achieving global development goals.

According to an Organization for Economic Cooperation and Development report released last week, total net ODA disbursements to fragile states dropped 2.4 percent from $54.7 billion in 2010 to $53.4 billion in 2011 (the most recent year data is available at the time the report was written). ODA to fragile states in 2012 dropped by an additional 0.3 percent in 2012, according to OECD data.

These numbers, and other warning signals, likely precipitated several donor pledges to increase their commitment to fragile states in 2013 and 2014.

Back in April, World Bank Vice President for Concessional Finance and Global Partnerships Joachim von Amsberg confirmed that available funds for fragile and conflict-affected states will be increased in the 17th replenishment of the International Development Association. A $52 billion pledge from donor countries has made it possible for this commitment to be carried out through June 30, 2017, when IDA-17 is set to end.

Von Amsberg, who oversees the replenishment, added that the bank is looking not only at boosting funding but also implementing operational changes to speed up project implementation. In 2011, the World Bank, through IDA, was the third-largest donor to fragile states, providing $4.6 billion in development assistance.

The Obama budget request for fiscal 2014 included $351.8 million to help “new and fragile democracies” make their governments more effective, transparent and accountable. It also requested $40 million for the Complex Crisis Fund, which finances projects that will help address and prevent “root causes of conflict and instability.” Further, the budget request allows for up to $7 million to be transferred to the Department of State’s Conflict and Stabilization Operations account.

In November, U.S. Agency for International Development Administrator Rajiv Shah stressed that as a way to end extreme poverty and promote inclusive growth, the agency will strive to engage fragile states better, including by tapping the private sector.

The United States was the largest donor to fragile states in 2011, disbursing nearly $13.3 billion in development assistance that year.

The European Union and the United Kingdom, meanwhile, have both emphasized their increased focus on fragile states. The bloc, through its Agenda for Change, has placed a special focus on fragile states. The United Kingdom, on the other hand, has pledged to spend 30 percent of its development assistance on fragile states by 2014. The European Union and the United Kingdom were the second- and fourth-largest donors to fragile states in 2011.

“We are hopeful that the announcements made by various donors — including the World Bank/IDA — will contribute to reversing the forecast trend,” Jolanda Profos, OECD peace and conflict adviser who co-authored the most recent fragile states report, told Devex.

The OECD’s survey of donors’ forward-spending plans for 2013 actually confirms higher spending on fragile states, and there are some early indications that donors will step up spending in 2014 as well. Based on the survey, Profos said ODA to fragile states is projected to increase by $3 billion from 2012 to 2013, “although it is then expected to stagnate up to 2016.” The OECD has started its survey of donors’ spending plans for 2014-2017 and will be releasing projections in April.

But even if donors increase development assistance to fragile states, aid is skewed toward high-profile countries. In 2011, more than half of ODA to fragile states went to only seven countries: Afghanistan ($6.7 billion), Democratic Republic of the Congo ($5.5 billion), Ethiopia ($3.5 billion), Pakistan ($3.5 billion), Kenya ($2.5 billion), West Bank and Gaza ($2.4 billion), and Iraq ($1.9 billion).

As a result, the remaining 44 fragile states received less than half a percentage of global development assistance. This list includes some of the poorest countries in the world, some of which also have the worst human development indicators, including Bangladesh, Chad, Eritrea, Madagascar and Myanmar.

“The post-2015 framework provides a further opportunity to re-think aid allocations,” Profos said. “Both bilateral and multilateral donors have a role to play in ensuring that the needs of poor people in fragile states are addressed.”

Tax reform to boost domestic revenues

Given unequal distribution of aid and a possible plateau in ODA to fragile states, the OECD report discussed several development finance alternatives, including remittances and foreign direct investment. Boosting domestic resources, primarily by improving tax administration and collection, was deemed the most sustainable alternative.

This is not a new financing mechanism, however. Donors pledged as early as 2002 to help poor countries increase their domestic revenues. More than a decade later, and the taxes fragile states are collecting account for less than 14 percent of their gross domestic product, on average. To meet the Millennium Development Goals, the United Nations estimated countries’ domestic revenues have to constitute at least 20 percent of their GDP.

“Donors are not fulfilling their promises to focus more on domestic revenues,” Jon Lomøy, director of the OECD’s Development Cooperation Directorate said in a news release. “We are missing out on a vital opportunity to invest in smart aid.”

In 2011, donors allocated only 0.07 percent of their ODA to fragile states to public financial management, including supporting tax reform. Traditional sectors, such as health and education, continue to receive the bulk of development assistance in these countries.

But this is the first time that ODA allocation to boosting domestic revenues has been published, Profos noted. “We are hopeful that donors will feel encouraged to spend more in this domain.”

The report highlighted examples where investing in tax administration resulted in positive returns, “even in the most challenging governance environments.”

In Ethiopia, for instance, a program that aims to build tax administration capacity is estimated to have yielded 20 pounds ($32.81) in government revenue for every 1 pound of U.K. Department for International Development support for the program. USAID’s support for tax reform in El Salvador, meanwhile, allowed the Central American country to boost government revenue by $350 million annually.

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About the author

  • Aimee Rae Ocampo

    As former Devex editor for business insight, Aimee created and managed multimedia content and cutting-edge analysis for executives in international development.