Foreign Aid

Bond markets and good governance—a match made in heaven

(January 31, 2011) Bond markets have taken the profligate Spanish government to task. Foreign aid officials take note.

The Spanish government—after being punished [PDF] by bond markets for its profligate ways—has responded by cleaning up its tax system [PDF] and cracking down on tax evaders. To date, Spain’s efforts have netted an additional $13.4 billion in tax revenue—equivalent to about 1 percent of the country’s annual gross domestic product.

According to reports, the Spanish government had little choice after international bond markets insisted on substantially higher interest rates [PDF] due to uncertainty over the country’s ability to repay its skyrocketing debt. The message from bond markets was the catalyst that is now forcing the Spanish government to come clean with its own public and go after tax evaders.

Governments, whether rich or poor, prefer to finance their operations on borrowed funds rather than taxes: better to postpone the day of accounting by borrowing against the taxpayers credit card than digging into his pocket today. But this approach can create nasty surprises for taxpayers, as the EU is discovering now with its spendthrift members. Bond markets help discipline irresponsible governments by raising state borrowing costs to scandalous levels and forcing governments to return to their tax base—the public—and face the music.

And so it is happening in Spain.

The Spanish story—of profligate spending with borrowed funds, rather than taxes—has very direct implications for leaders in the developing world.

Foreign aid, say its critics, allows Third World officials to avoid building a strong domestic economy and establish a fair and transparent tax system. When governments don’t depend on their own people for financing, citizens lose their single most powerful tool to discipline their governments, and attempts to establish accountable governance are futile. Government officials and their cronies are free to loot the state, investors soon flee, the economy becomes moribund, and Third World countries end up as wards of the rich countries who keep them on foreign aid life-support.

If they are ever going to thrive, Third World countries should be weaned off foreign aid, say more and more development experts, such as Patricia Adams of Probe International.

“Without aid, Third World governments will need to raise funds through taxes and bond markets. Bond markets will test a country’s economic and political management, while the tax base will constantly test a government’s legitimacy with its own people. If well run, the two will reinforce each other in a virtuous circle,” she says.

To rely on international capital markets, Third World governments need clear and prudent plans for domestic growth and tax collection. If a government is unable to provide such plans or has an unwieldy deficit and a high tolerance for tax evasion, bond markets make them pay—as the Spanish case shows.

Bond markets, it turns out, are a taxpayers’ best friend, punishing profligate governments and pushing them to reform taxes for transparency, honesty, and legitimacy. Assuming, that is, that foreign aid donors don’t bail the errant governments out.

As citizens begin paying their taxes they develop the tools to hold their government to account—making the saying, “no taxation without representation” and its counterpart, “no representation without taxation,” a reality.

This is not simply a theoretical exercise. A number of leaders in the developing world are now calling for reform of their tax systems as the best way to end foreign aid dependence.

Seth Terkper, Ghana’s Deputy Minister of Finance & Economic Planning, speaking last year at a conference said African governments should no longer rely on foreign aid as a means to promote development in their countries.

“What we need is a capable tax administration system that is able to collect revenue for the state, deal with tax evasion and avoidance and build a compliance culture,” he said. “Our aim must be to mobilize domestic resources to the extent that they fund the domestic development agenda.”

Terkper’s remarks come after a number of African leaders, speaking at a conference at the World Economic Forum on Africa, called for reform of the tax system, pointing out that Africa currently has one of the lowest tax-to-GDP ratios in the world.

South African Finance Minister Pravin Gordhan, Mozambican President Armando Guebuza and African Development Bank President Donald Kaberuka, admitted that the African continent lagged behind most other parts of the world when it comes to tax collection. They all called for greater tax reform.

Meanwhile in Pakistan, the country’s Federal Minister for Finance and Revenues, Shaukat Tareen, has gone on record saying that if the government were able to increase revenues from tax collection, contentious foreign aid packages, such as the US Kerry-Lugar bill that sparked weeks of protests last year, would be unnecessary.

Brady Yauch, Probe International, January 31, 2011

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