Aid, Tax & State Building

Tax is the most important, the most beneficial, and the most sustainable source of finance for development.

We believe there is a role for foreign aid. But it can foster rent-seeking by political élites; and it can make rulers feel accountable to foreign donors rather than to their own populations. Aid is volatile, comes with strings attached, and can also foster capital flight.

And ultimately, aid cannot match the revenue-raising potential of tax. Tax revenue in Africa, for example, is worth ten times the value of foreign aid. The long-term goal of poorer countries must be to replace foreign aid dependency with tax self-reliance.

Tax serves several big purposes. The most obvious is to raise revenue: to pay for health, roads and education – or for more indirect benefits like courts systems and the rule of law. A tax system can also redistribute wealth and income and tackle inequality. Different taxes have different effects here: income taxes, corporate and capital taxes, and property taxes are usually progressive: they reduce economic inequalities. Indirect taxes such as Value Added Tax or VAT are generally regressive, though they are useful for raising revenues too. Corporation taxes are particularly precious for poorer countries, whose under-resourced tax administrations find it easier to tax them than to tax large numbers of often very poor people.

Tax has other roles too. Less well known is the role it plays in promoting better governance. American colonists who were being taxed under British colonial rule famously demanded “no taxation without representation.”  If citizens are going to pay tax, they will push for better and more accountable government in return. Historians looking at prosperous western economies have long understood how taxation has promoted the rise of accountable, responsive states. New scholarship is finding that this is true for developing countries too. As one account puts it:

“Tax is the new frontier for those concerned with state-building in developing countries. The political importance of tax extends beyond the raising of revenue. We argue in this book that tax may play the central role in building and sustaining the power of states, and shaping their ties to society. The state-building role of taxation can be seen in two principal areas: the rise of a social contract based on bargaining around tax, and the institution-building stimulus provided by the revenue imperative. Progress in the first area may foster representative democracy. Progress in the second area strengthens state capacity.”

Tax is the nexus between state and citizen, and tax revenues are the lifeblood of the social contract. Tax havens undermine this fundamental relationship, whether through providing the secrecy that encourages wealthy élites to loot their local economies and hide their winnings offshore, or through facilitating corporate tax avoidance that deprives developing countries of revenue.