Fiscal capacity

Fiscal capacity is the ability of the state to extract revenues to provide public goods and carry out other functions of the state, given an administrative, fiscal accounting structure. In economics and political science, fiscal capacity may be referred to as tax capacity, extractive capacity or the power to tax, as taxes are a main source of public revenues. Nonetheless, though tax revenue is essential to fiscal capacity, taxes may not be the government's only source of revenue. Other sources of revenue include foreign aid and natural resources. Fiscal capacity is the ability of the state to extract revenues to provide public goods and carry out other functions of the state, given an administrative, fiscal accounting structure. In economics and political science, fiscal capacity may be referred to as tax capacity, extractive capacity or the power to tax, as taxes are a main source of public revenues. Nonetheless, though tax revenue is essential to fiscal capacity, taxes may not be the government's only source of revenue. Other sources of revenue include foreign aid and natural resources. In addition to the amount of public revenue the state extracts, fiscal capacity is the state's investment in 'state structures—including monitoring, administration, and compliance through such things as training tax inspectors and running the revenue service efficiently'. When investment in these administrative or bureaucratic fiscal structures are specific to the state's power to extract resources, fiscal capacity is moreover related to a larger concept of state capacity. Finally, given that public goods funded by fiscal capacity include infrastructure development, health, education, military and social insurance, a state's fiscal capacity is essential to its economic growth, development, and state-building. Fiscal capacity is the ability of the government to raise revenues, and is frequently measured as the proportion of gross domestic product generated by tax revenue. Overall, wealthier developed countries have larger, stronger tax administrations and raise more money through tax revenue than poorer, developing countries. As is such, the more revenue a government collects, the greater fiscal capacity is. However, fiscal capacity is measured not only by the level of tax revenue a state is able to raise, but by the tax administration's ability to enforce tax policies. Besley and Persson (2012) present a list of 'stylized facts' that describe the evolution and patterns of fiscal capacity. These facts are patterns identified from an analysis of cross-sectional and time series data on 73 countries since 1800: Fiscal capacity changes from state to state, not only in the amount of tax revenue that each state is able to extract but also the way in which revenue is extracted. Specifically, different types of taxes are considered more economically efficient, and accordingly more ideal, than others. More information can be found on tax types and economic efficiency in the page on Tax. The strength of a state's fiscal capacity is thus determined by not only the amount of revenue collected, but also influenced by the efficiency of its tax structure. For instance, optimal taxation theory states that the ideal tax structure maximizes efficiency; inefficient taxes include the corporate income tax, tariffs and seignorage, while efficient taxes include income taxes and consumption taxes such as the value-added tax. As is such, richer developed countries and states with strong fiscal capacity tend to rely on these efficient tax types, whereas the opposite holds true for poorer, developing countries. Poorer countries tend to rely on less efficient tax types, and accordingly have weaker fiscal capacities. Likewise, developing countries with weak fiscal capacities are more likely to be unable to provide public goods. The social science literature on fiscal capacity and economic development aims, in part, to solve this puzzle of why developing countries cannot strengthen fiscal capacity by simply increasing their use of efficient tax types and lowering the use of inefficient tax types. Low fiscal capacity is typically a consequence of underdeveloped political, social and economic conditions in a state. First, as countries differ in their investments on the military, public education, infrastructure (etc.), different tax structures can reflect varying preferences for private versus public goods, and redistribution. Secondly, inefficient tax structure and weak fiscal capacity indicate the presence of tax evasion, a relationship that is further examined in the section below on the informal economy. Overall, favorable tax types are correlated to greater fiscal capacity because they impose fewer economic efficiency costs, but also encourage more efficient tax collection by minimizing tax evasion. When fiscal capacity is weak, governments are not able to monitor or tax the entire population. The informal economy is the part of the economy that is not monitored by the government. It exists when the general population can easily evade taxes due to factors such as low tax-morale, low-quality governance, and insufficient resources for large, quality tax administrations like that of the US's Internal Revenue Service. Likewise, informal economies have a larger presence in developing countries. In 2000, Friedrich Schneider and Dominik Enste estimated that the size of 'the informal economy on average is only about 15% of GDP among OECD countries... However, among developing states, the median size of the informal economy they report is 37% of GDP, ranging from 13% of GDP in Hong Kong and Singapore to 71% in Thailand and 76% in Nigeria.' Informal economies also explain why developing countries cannot simply raise tax rates, like in their more developed counterparts, to attain a higher GDP or fund more public goods.