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Journal of Globalization and Development

Ed. by Stiglitz, Joseph / Emran, M. Shahe / Guzman, Martin / Jayadev, Arjun / Ocampo, José Antonio / Rodrik, Dani


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Does Foreign Aid Displace Domestic Taxation?

Patrick Carter
Published Online: 2013-10-11 | DOI: https://doi.org/10.1515/jgd-2013-0023

Abstract

The existence of a negative relationship between aid and taxation would have far-reaching implications for international development agencies. This paper applies some recent methodological advances to the question and also discusses a range of problems with existing research. Previous results, which tend to show a negative relationship, are often based on econometric methods that rest on potentially restrictive assumptions. When more general methods, Panel Time Series estimators and the Group Fixed Effects estimator, are applied, there is little evidence that aid displaces domestic taxation.

Keywords: Foreign Aid; Taxation; Panel Time Series

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About the article

Corresponding author: Patrick Carter, Department of Economics, 8 Woodland Road, Bristol, Avon BS8 1TN, UK, Phone: +44 (0)117 33 10500, e-mail:


Published Online: 2013-10-11

Published in Print: 2013-08-01


For example, the Penn World table 7.1 covers 189 countries and 60 years. Panel estimators employed in much previous research into the aid-tax relationship, such as fixed-effect estimators or the Difference and System GMM estimators, were mainly developed for microeconomic applications, typically for labour or firm-level applications, where N is large and T small.

Group membership is estimated from the data. Unlike Panel Time Series estimators, the GFE estimator assumes that the relationship between aid and taxation is homogeneous across countries.

Examples of widely-cited papers are Easterly and Rebelo (1993), Devarajan et al. (1996), Sala-i-Martin et al. (2004) and Gupta et al. (2005).

The weights in the government’s objective function are also estimated. The exogenous budget targets are usually estimated in a first-stage regression, which is where the effect of aid upon those targets would be felt. See Van de Sijpe (2010) for an analytical review.

Gambaro et al. (2007) conduct essentially the same exercise with the same result.

Marchesi and Missale (2013) report that whilst the level of net transfers is unaffected, more highly indebted IDA countries are allocated more grants and fewer loans, a pattern they describe as “defensive granting.” But they do not explore whether indebtedness is associated with poor tax performance. Because lending is often accompanied by debt forgiveness, the distinction between a grant and a loan is not clear cut. However, if loans are grants by another name, the rationale for the hypothesized differential impact upon taxation disappears. In any event, it seems unwise to assume the choice between grant or loan is random with respect to the recipient country’s expected path of tax revenues.

Evidence for increasing selectivity in aid allocation is mixed: see Dollar and Levin (2006) and Clist (2011). Over the longer-run, because donors target poor countries and poorer countries tend to have lower effective rates of taxation, one might expect non-random aid allocation to introduce a downward bias to estimates. Accordingly, Arndt et al. (2013) find a positive relationship between aid and tax in a long-run cross-section when estimated by OLS, the magnitude of which roughly trebles after instrumenting for aid to account for non-random allocation.

An alternative term of somewhat narrower scope is quality of “governance.” See Baland et al. (2010) for discussion.

Acemoglu (2010) points out that strengthening the state is beneficial when part of an endogenous process in which restraints on executive power are also strengthened, and that an exogenous increase in tax raising capacity may worsen the political economy.

Besley and Persson (2009a) use reliance on trade taxes as a negative indicator of state capacity, Dincecco and Prado (2012) use non-trade taxes as their measure of state capacity.

From data compiled by Francis K. T. Ng at the World Bank, available on the World Bank Data on Trade and Import Barriers webpage.

Aid in the form of direct imports is often tax exempt. But this is not always the case. A particularly egregious example is the payment of 300% import duties on 25 Indian-made 4-wheel drive vehicles donated to the Sri Lankan government by the charity Oxfam, after the 2005 Tsunami. See “Oxfam pays $1m tsunami aid duty,” BBC Online 17 June 2005. Furthermore, when aid is used to purchase domestically produced goods and services, it can only be absorbed indirectly, for example after aid dollars are sold on the local currency market, so the resulting imports would not be identified as aid.

An updated dataset, augmented with dummy variables identifying instances of donor-instigated policy reforms with fiscal implications, might have the potential to provide a better picture of the relationship between aid and taxation, but compiling such data would be a formidable task involving many subjective judgements, and is not pursued here.

The World Bank sponsored 467 public sector reform projects between 1990 and 2006, for example.

There is a parallel here with the empirical consumption literature, where changes in consumption are (sometimes) found to anticipate rather than respond to changes in income, in accordance with (some) consumption theories. See Campbell (1987) and Carroll (1994), among others.

This dataset replicates, as far as possible, that used by Crivelli et al. (2012). It was not possible to replicate fully the results in Crivelli et al. (2012) because the authors have access to proprietary estimates of tax revenue from annual IMF consultation reports, which they used to fill some of the gaps in publicly available data. Their data cover 118 countries but data used here only cover 110 countries. See Appendix A for full details.

Crivelli et al. (2012) find a negative relationship using fixed-effects (Table 1, column 4).

Results are shown in Table A1 using the 2nd through to the 4th lag of aid as instruments. The estimated relationship is significant when using only the 2nd lag and, in the case of System GMM, sometimes when using more lags. See Appendix A.

The fully disaggregated taxation data used by Crivelli et al. (2012) are available for roughly 50 countries; the dependent variable used here, total taxes minus trade taxes, is available for 109 countries.

The following exposition draws heavily upon Smith (2001).

Estimates of long-run relationships from individual-country error-correction models are illustrated in Figures 36 of Appendix B.

Informally, if the assumption of an homogeneous long-run effect is valid, the PMG procedure can be thought of as using the assumption of similarities between countries to see through the noise of individual country regressions, to recover a more informative estimate.

The GFE estimator is available from the personal webpage of Stephane Bonhomme.

Bonhomme and Manresa (2012) suggests an appropriate BIC to select the number of groups [Equation (27)]. The researcher must specify a maximum number of groups; here a maximum of 5 was set and the BIC suggests 5 groups is the optimal number of groups. But it seems unwise to place much weight on this criteria in small sample and a model that is a relatively poor fit.

The taxation data used in this paper were made available by kind permission of Crivelli and co-authors, but are not yet in the public domain.


Citation Information: Journal of Globalization and Development, Volume 4, Issue 1, Pages 1–47, ISSN (Online) 1948-1837, ISSN (Print) 2194-6353, DOI: https://doi.org/10.1515/jgd-2013-0023.

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