According to a recent IMF analysis, low-income developing countries will need resources equal to 14.4 percent of their gross domestic product on average to meet the Sustainable Development Goals in five areas: education, electricity, health, roads, and water.
One way to bridge this gap is by strengthening the domestic tax capacity of LIDCs, which could mobilize roughly 40 percent of the needed resources, or 5 percent of GDP, with official development assistance and flows from the private sector and civil society providing the remaining. The International Monetary Fund analysis further indicates that fewer resources would be required if LIDCs were to grow at exceptionally high rates through 2030 and if this money was well spent.
However, generating additional revenue equal to 5 percent of GDP in LIDCs will be challenging, given past trends in revenue performance and the political opposition that tax reforms are likely to face in these countries. This makes it imperative for policymakers to improve the efficiency of existing spending, which could potentially generate as much incremental resources as domestic taxation.
Past trends and the Addis Tax Initiative
In recent years, LIDCs have overall been 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.
This reflects the implementation of tax reforms — including the adoption of modern taxes such as the value-added tax — and the strengthening of tax administrations with strong support from the international community, including the international institutions, in the form of technical and financial assistance to acquire modern systems. Under the Addis Tax Initiative, launched in July 2015, international institutions and donor countries are committed to scaling up assistance to LIDCs for building tax capacity.
There is significant potential for raising additional resources, but major challenges need to be overcome.
Recent IMF and World Bank studies suggest that broadening tax bases and improving compliance in LIDCs could generate an average of 3-5 percent of GDP in additional revenue. How much of a tax increase is feasible in each LIDC will depend on its institutional capacity and the starting point. For example, roughly half the countries of sub-Saharan Africa are considered fragile — meaning they have weak institutional capacity with scores of 3.2 or less on the World Bank Country Policy and Institutional Assessment, and/or they have experienced conflict in the past three years. These countries have significantly lower tax capacity than non-fragile states, and they will take longer to build their tax systems.
In general, strengthening tax capacity in LIDCs is likely to take time, not least because of the need to generate political support for reforms. Reforms in areas with revenue potential such as tax expenditures, property taxes, and personal income taxes are likely to be opposed by vested interests. In many countries, tax expenditures — tax concessions given to certain consumers and producers — are 5 percent of GDP or more. And in some countries — such as Ghana, Dominican Republic, and Guatemala — they amount to 40 percent of tax collections.
Without enhanced scrutiny of tax expenditures, any revenue gains elsewhere would be frittered away through granting of tax concessions in a nontransparent manner, with little or no increase in overall tax-to-GDP ratio. Tax concessions in personal and consumption taxes (such as the value-added tax) are likely to become more dominant in coming years and could limit the amount that countries could raise from these taxes.
Property taxes are another area with revenue potential, but governments are likely to face resistance from middle classes. On average, LIDCs collect less than 0.5 of GDP from property taxes, as opposed to 2 percent of GDP in advanced economies. Property taxes are progressive, and with worsening income distribution and rising property prices in many LIDCs, there are good reasons to start building capacity in these countries to collect them. The advent of new technologies — particularly satellite and digital — should help in this regard.
Enhancing the efficiency of existing spending
Even if these challenges are overcome and taxes in LIDCs grow at a faster pace in the next 12 years than in the previous 12, that will still not be sufficient to fund the SDGs, as the IMF’s math shows. This means that tax-enhancing efforts must be complemented with improving the spending side of the budget.
On average in 2015, LIDC governments spent around 7 percent of GDP on education and health and up to 8 percent of GDP on public investment. Various studies show that LIDCs are not undertaking this spending at the lowest possible cost. Some countries, notably African nations, use 25-35 percent more inputs in both the education and health sectors to produce the same outputs as more efficient countries. Inefficient spending costs LIDCs more than one-third of their public investment.
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. That’s close to the expected gains from improved domestic taxation. And there are even more possible expenditure savings — for instance, in rationalizing the generalized subsidies on petroleum.
LIDCs and international institutions can take steps to ensure policymakers don’t lose sight of how spending is undertaken in budgets. Countries should periodically review their spending programs, either on their own or with assistance from external experts to identify inefficiencies. Further, assistance from international institutions and donor countries should extend beyond strengthening tax systems to enhancing the efficiency of spending programs. How countries spend their revenues should be a central part of this support.
By focusing on both sides of the budget, rather than just increasing taxation, countries can generate more resources domestically and make faster progress on achieving the SDGs. And, perhaps most importantly, generating financing internally rather than from external sources is more sustainable and puts LIDCs in control of their own destinies over the long term.