How to increase the fiscal space

To understand the straits many governments find themselves in, it helps to take a long-term perspective. Starting from the late 1970s, it has become increasingly difficult to raise taxes. It was much easier earlier, in the era of regulated capitalism after World War II. The top marginal income tax rate was 97 % in India at one point. In Britain the highest rate was 95 % and even in the USA it was 92 %.

In the post-war period, economic growth was strong. Public spending served to build infrastructure and to reduce inequality. In both developed and developing countries, productivity increased fast. An unintended side-effect was a propensity towards tax evasion; but it was not strong enough to undermine the resource mobilisation and developmental capacity of states.

A paradigm change soon followed with the ascendancy of market fundamentalism since the early 1970s, led by Prime Minister Margaret Thatcher in Britain and President Ronald Reagan in the USA. The World Bank and the International Monetary Fund were strong proponents as well. The emphasis was now on the unrestrained flow of goods, services and capital internationally. Market dynamics were expected to deliver the best results, and the economic policy autonomy of nation states was reduced dramatically. The era of neoliberal globalisation had begun.

A well understood consequence was that finance capital has become extremely powerful. The flow of money across borders today far exceeds transactions related to trade and productive investments, in large measure due to speculation focused on a host of different financial assets including company shares, government bonds, currencies, commodity futures and other derivatives. Although measuring financialisation is tricky and complex, a simple estimate – the ratio of the value of global financial transactions to the value of transactions in global trade – points towards the gravity of the issue.

This ratio increased by a factor of 45 from 2:1 in 1973 to 90:1 in 2004. Indeed, in 2017, the annual value of the global trade was $ 17.9 trillion. By comparison, the financial transactions amounted to 5.1 trillion per day that year, according to a Transnational Institute publication by Frances Thomson and Sahil Dutta (2018).

Marathon run to the bottom

Financial investors do not like income and corporate taxes. Accordingly, governments around the globe reduced their tax rates. A marathon run to the bottom began, with nations gradually reducing tax rates to keep their economies competitive. In prosperous nations, the marginal top rate is now typically below 50 %. Wealth and inheritance tax, which investors resent even more, withered away as well.

Governments around the world increasingly began to rely on indirect taxes such as the value added tax, which hit spending for consumption purposes and particularly hurt low-income households which must spend most of the money they earn to fulfil their daily needs.

The cumulative result has been that all nation states are now struggling to generate the tax revenues they need. As a result, sovereign debt has soared around the world, with government spending increasingly being financed with the sale of bonds. Bonds are basically loans to the government that issues them.

The situation is particularly difficult in developing countries. The members of the OECD (Organisation for Economic Co-operation and Development), a club of high-income countries, on average have a tax-to-GDP ratio of 33 %. The range of tax-to-GDP ratio for low- and middle-income countries lies between 10 % to 30 %, mostly towards the lower end. Although different international agencies estimate tax-to-GDP ratios differently, the basic insight is the same: The developing world is actually closer to market fundamentalists’ ideal of a “small state”, in which there is little government interference in economic life, than OECD nations are.

Long list of challenges

The international community today must cope with multiple crises. The list of problems is long and includes global warming, the erosion of biodiversity, high inflation, excessive sovereign debt, lingering impacts of the pandemic, the consequences of Russia’s attack on Ukraine and more. Quite obviously, governments cannot rise to the challenge unless their fiscal space increases. This is particularly true of developing and least developed countries. Typically, their national debt is high and dollar denominated. A higher exchange rate means the debt burden increases because it takes a larger share of their GDP measured in the national currency (see André de Mello e Souza on www.dandc.eu).

Further, their tax revenues remain low due to two reasons:

• Many people’s livelihoods still depend on subsistence farming, which is not monetised and thus does not count.
• There is very much informal economic activity, which largely bypasses legal regulations and is not taxed.

The smaller a country’s GDP per capita is, the lower its tax revenues tend to be. Therefore, the governments of low-income countries find it especially hard to build infrastructure and provide public services.

It is therefore important to focus on how to widen and deepen the tax base. There are several critical issues in this context, including especially the collection of direct taxes on income and wealth, the reliance on social-protection levies and the curbing of illicit financial flows (see box).

ODA is not a big deal

International debate tends to focus on official development assistance (ODA) as though it were of crucial importance. According to the OECD, the governments of high-income countries spend about $ 179 billion on assisting the developing world. That is roughly twice the amount of illicit financial flows from Africa alone, if one trusts UN estimates. Illicit flows, of course are impossible to measure precisely, and other sources put the figures much higher. In 2012, the illicit financial flows out of developing countries probably amounted to $ 1 trillion according to a working paper published jointly by the International Labour Organization, UNICEF and UN Women (Ortiz et al., 2017). The ODA developing countries received that year from OECD nations, however, was one eighth of that amount, a mere $ 120 billion.

The truth is that ODA is really only a tiny fraction of the total international transactions. In past decades, far more money has moved from the global south to the global north. Aid thus only amounts to a small band-aid on a blistering wound. Concerted action to relieve and restructure sovereign debt, however, would help many economies in crisis today, especially as the rising exchange rate of the dollar is making their debt burden harder to service.

Moreover, ODA pledges keep being broken. Since the 1970s, the high-income countries were supposed to pay 0.7 % of the gross national income. On average, they are now paying 0.33 %. It fits the picture that climate-finance promises are not being fulfilled dutifully either. Quite obviously, that must change.

All these things matter, but they will stay very hard to implement unless the international community adopts a new paradigm that focuses more on real-economy problems than on the flimsy preferences of finance capital. Market dynamics have not prevented the escalating crises we are facing. To a large extent, they have made them happen. Instead of empowering oligarchs, public policy must serve to fulfil the daily needs of the masses and ensure the sustainability of nature, on which the viability of each and every society depends.

Another paradigm change?

In the current context, it is becoming increasingly clear that the ideology of the “small state” is a recipe for disaster. The next paradigm shift may actually be under way. It was fascinating how financial markets recently punished Liz Truss, Britain’s seven-week prime minister, for policy choices that were meant to please them. Truss wanted to cut taxes and increase debt. Investors responded by driving up the costs of bonds, making her strategy unfeasible and forcing her to resign.

As proposed by Nigeria on behalf of African nations, the UN has agreed to negotiate a tax convention and set up a new global tax body. While OECD nations had already started cooperation on better tax enforcement, low-income countries will benefit from relying on the more inclusive UN context. 

The rhetoric of the International Monetary Fund and the World Bank, moreover, has changed too, though their stance in negotiations with low-income countries has largely remained the same (see Kristina Rehbein and Malina Stutz on www.dandc.eu). This, of course, is where change is most needed.

References

Ortiz, I., Cummins, M., and Kurananethy, K., 2017: Fiscal space for social protection and the SDGs.
https://www.social-protection.org/gimi/RessourcePDF.action?id=51537

Thomson, F. and Dutta, S., 2018: Financialisation: a primer.
https://www.tni.org/en/publication/financialisation-a-primer

Praveen Jha teaches economics at Jawaharlal Nehru University (JNU) in Delhi.
praveenjha2005@gmail.com