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. Another source of revenue is foreign aid.

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.

Definitions and Patterns

Because fiscal capacity is the ability of the government to raise revenues, a frequent measure of fiscal capacity is the proportion of total wealth or 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 country raises, the its 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 quality and size of the tax administration itself, as well as the 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 come from an an analysis of cross-sectional and time series data on 73 countries since 1800:
"Stylized Fact 1: Rich countries have made successive investments in their fiscal capacities over time.
Stylized Fact 2: Rich countries collect a much larger share of their income in taxes than do poor countries.
Stylized Fact 3: Rich countries rely to a much larger extent on income taxes as opposed to trade taxes than do poor countries
Stylized Fact 4: High-tax countries rely to a much larger extent on income taxes as opposed to trade taxes than do low tax countries.
Stylized Fact 5: Rich countries collect much higher tax revenue than poor countries despite comparable statutory rates."

Tax Structure

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 each state extracts revenues. Different types of taxes are collected in different ways, and certain tax types and tax collection methods are considered more economically efficient--and thus more ideal--than others. More information can be found on tax types and economic efficiency in the page on Tax. Nevertheless, the level of fiscal capacity is determined by not only the presence of taxation, but the types of taxation or tax structure.

For instance, Optimal taxation theory states that the ideal tax structure maximizes efficiency and consists of "no tarrifs, no taxes on capital income, uniform taxes on consumption, and deflation". Generally, taxes considered inefficient are narrow-based taxes such as tarrifs and seignorage, and efficient taxes are broad-based taxes such as income tax, value-added taxes, and the corporate income tax. Better tax structures are correlated to greater fiscal capacity because they encourage more efficient collection, deter tax evasion, and impose fewer economic efficiency costs. States with high fiscal capacity thus raise revenue "in a way that does not impose large distortions in relative prices", namely the use of more efficient tax types.

A common pattern is that developed, richer countries and states with strong fiscal capacity tend to rely on these efficient tax types like the income tax and consumption taxes, whereas the reverse holds true for poorer, developing countries. Instead, poorer countries rely on less efficient tax types, such as corporate income taxes, tariffs, and seignorage. This pattern is puzzling given that public finance literature frequently emphasizes the revenue-maximizing potential and efficiency of income and value-added taxes and the lack of that with tariffs or seignorage. Social science literature on fiscal capacity aims to solve this puzzle.

Additionally, different tax structures reflect preferences for private versus public goods and redistribution. Because countries differ in their investments on the military, public education, infrastructure (etc.), tax structure and fiscal capacity can reflect the the different social, political and economic identities of each state. Accordingly, poor states or developing countries with low fiscal capacity are more likely to be unable to provide public goods.

Moreover, fiscal capacity reflects the political, social and economic conditions of a state effect. In particular, the presence of a large informal sector is correlated with weaker fiscal capacity. For instance, Friedrich Schneider and Dominik Enste estimated the 2002 size of the informal sector for a variety of countries. They find that "the informal economy on average is only about 15% of GDP among OECD countries, and thus small enough that it should not be a driving force in the choice of tax structure. However, among developing states, the median size of the informal economy they is 37% of GDP; examples range from 13% of GDP being attributed to the informal economy in Hong Kong and Singapore to 71% in Thailand and 76% in Nigeria.

Overall, tax policy shapes a state's fiscal capacity, fiscal capacity describes the government's ability to provide public goods, and both the strength and the structure of fiscal capacity varies across states. Evidenced by the aforementioned patterns, the discussion regarding fiscal capacity very much revolves around the comparison of tax structures between poor and rich, developing and developed countries, finding a solution for weak fiscal capacity.

Fiscal Capacity in Practice

Administration

A state's fiscal capacity is determined twofold; the amount of revenue that tax administration is able to raise, and the amount of resources that go into producing a tax administration.

In "Administrative Dimensions of Tax Reform", Richard Bird explains that the strength of a tax administration is determined by the number of trained personnel, adequate infrastructure (including technology and modern computer systems), as well as a functioning "information system". This information system determines the tax base, as well as identifies, classifies and monitors taxpayers. It further facilitates the collection of information from each individual, third parties, and other sources from within the tax administration. In addition, there should also exist a system of rewards and penalties to enforce tax compliance. And finally, there must be a system to both redress grievances and complaints should the system fail, and identify and address mistakes with the tax system before they occur. Tax administrations are complex and require a vast amount of resources that not all states can afford.

Fiscal capacity and tax structure depends immensely on the strength and capabilities of the administration itself. A revenue service acts as a monitoring body that aims to enforce compliance and deter tax evasion. As is such, different tax policies and structures may indicate the different ways countries deal with tax evasion in accordance to the different social and political situations that take place in each state. For instance, the Internal Revenue Service is an example of a strong tax administration, as it has a large number of employees and can therefore more easily monitor each individual in the US. On the other hand, where poorer countries lack tax personnel, an inefficient tax such as border tax is much easier to monitor. As discussed in the section on Tax Structure, while tariffs are less efficient and impost greater deadweight loss on an economy, the recommended income taxes are much easier to evade.

In practice, collecting large amount of tax revenue without the use of inefficient taxes becomes complicated in the presence of tax evasion. A tax administration's goal is to therefore not simply maximize revenue and economic efficiency, but to monitor the peoples of a state and facilitate tax compliance.

Informal Economies

Despite the superior efficiency of certain tax types compared to others, taxes traditionally considered inefficient may better achieve fiscal goals in the presence of informal economies. By definition, informal economies are part of the economy that is not monitored or taxed by the government, and as is such informal economies signal low fiscal capacity because state-agents do not have the ability to effectively monitor and collect revenues from its populace. Informal economies exist when the general population can easily evade taxes due to factors such as low tax-morale, low-quality governance, and insufficient resources for large, administrative tax structures like that of the US's Internal_Revenue_Service. 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. In particular, when large informal economies exist and taxes are raised, people are more inclined to shift out of the formal sector into the Informal_sector of the economy. States with regions culturally unaccustomed to the idea of tax collection suffer from low tax morale, and are even more likely to circumvent the state's attempt to impose taxes. Thus, compliance depends on the social and political environment of the state as well as the ability of "effective bureaucracies [to] facilitate trust between government officials and the citizenry."

As a solution to tax evasion, governments place less efficient but more easily monitored taxes; for instance whereas it is difficult to track the incomes for each individual within the population in order to collect income taxes, it is much easier to impose an import/export tax at specific checkpoints along the border. Tariffs are easier to collect because they require fewer technological or administrative resources, and do not necessarily require depend on a strong cultural of tax compliance. Additionally, Emran and Stiglitz (2005) argue that "tariffs may provide a less distorting source of tax revenue" given this shift from formal to informal sectors. In other words, if certain types of taxes incentivize the general population to move into an informal economy out of the control of the government, it may be in the government's best interest to exact tax types that will discourage tax evasion in spite of economic efficiencies.

All in all, states with low fiscal capacity tend to use inefficient tax types when large informal economies are present, and if they do not have the administrative capacity to support the collection of efficient taxes.

Models of Tax Evasion

Besley and Persson's (2012) created an Economic_model to understand non-compliance, and why developing countries are not able increase their fiscal capacity by simply raising taxes. Focusing on taxes on income and services and goods at the household level (in comparison to corporate income taxes for businesses), Besley and Persson's model demonstrates that citizens always have the incentive to evade taxes, so as to keep the otherwise taxable income to themselves; they will only choose not to evade if the cost of evasion (i.e. a tax penalty) is too high. This cost depends on the government's ability to monitor individuals and sales, and enforce penalties. In other words, whether or not citizens choose to participate in the informal economy depends on previous investments in fiscal capacity.

In comparison, Gordon and Li (2009) study tax evasion at the firm level, paying particular attention to the importance of the financial sector when comparing fiscal capacity between developed and developing countries. They model businesses' participation in the financial sector--where Gordon & Li specifically refer to participation in the financial sector as using banks--as participation in the formal sector; since tax authorities can easily monitor bank records, the use of banks essentially gives the state the power to tax. Gordon and Li (2009) demonstrate that in developed countries, because the financial sector, businesses will choose to use banks and not evade taxes. On the other hand in developing countries, the financial sector may be weaker and businesses will have less incentive to participate in the formal sector; as is such, the other authors conclude that "as the financial sector improves in effectiveness, more firms will be pulled into using it in spite of the tax implications of doing so".

Origins

As fiscal capacity refers to the state's ability to collect revenues, social science theory on the history and evolution of fiscal capacity has to do with understanding the origins of the state itself. Economic history highlights the importance of revenue collection in the evolution from the pre-modern state to the modern state, and has likewise proved essential to understanding the fiscal differences between developed and developing countries. Crucial to economic models and historical theories about fiscal capacity such as that of Besley and Persson, Charles Tilly, Gordon and Li, Jim Scott et al., are the different actors that create and shape fiscal, and likewise state, development. Broadly put, much of the social science literature on the topic assumes that the origins of fiscal capacity lie in the decisions, incentives and constraints of different, self-interested actors that compete against one another. These agents compete for power and resources.

Actors

In "Seeing Like a State", James Scott for instance examines fiscal capacity through the competitive relationship between state agents and the general population. Essential to Scott's analysis is the consideration of actors beyond the state. In addition to the political actors who collect tax revenues, determine tax structure and build tax administrations directly, Scott highlights the power that citizens and local elite have in threatening the supply of an economic resource (tax revenue) to the state. Specifically, if the state suffers from poor fiscal capacity--meaning, lacking "both the information and the administrative grid that would have allowed it to exact from its subjects a reliable revenue that was more closely tied to their actual capacity to pay"--the citizens of the state can migrate away or leave the state, quietly resist or violently revolt against the state, or evade taxes.

Beyond Scott's metaphor, Besley & Persson (2009) further demonstrate that as the fiscal capacity of state changes over time, the choices that policymakers can make to change fiscal capacity depends on legal, political, and fiscal constraints imposed by the policymaker and other actors that previously held power. North and Weingast (1989) for instance, stressed "the importance of the imposition of constitutional constraints after 1689 in reining in the power of the monarch as a precondition for the subsequent success of the English state and economy." In a summary of literature regarding fiscal capacity, Johnson and Koyama (2015) further highlight an agreement among historians, that watershed moments in "the constitutional and fiscal history of England" as well as the "important role played by political elites and the formation of political parties" were essential to "granting the state previously undreamt of powers to raise taxes, spend and borrow" while preventing the crown from later exploiting the power to tax for itself.

"What limits the ability to tax are incentive constraints tied to asymmetric information, or perhaps political motives, rather than the mere administrative capabilities of the state" (Besley & Persson, 2011). <br Johnson & Koyama emphasize the goals of elite in their explanation of lessons learned from economic history in current public finance economics: "stronger fiscal and legal institutions can lead to economic development, [but] it is not so clear where the support for these institutions comes from initially. Frequently it is the private-order institutions--such as family alliances, religious organizations, or informal trade networks--which from the bases around which public-order institutions are eventually built."

War

Political historians, such as Samuel_P._Huntington and Charles Tilly, view war as the primary incentive for states to invest in fiscal capacity. In War Making and State Making as Organized Crime, Tilly models the government as a self-interested, power-holding actor that wishes to extract revenue from its less-powerful populace; however, the state also protects the populace from external threats in exchange for the resources and revenues that populace provides. Likewise, a government or state has an incentive to make war against other states if it believes it will be successful, as it will then be able to collect more tax revenues from an expanded domain.

Tilly defines four main actions of the state as "war making, state making, protection [and] extraction", where "extraction" is "the means of carrying out the first three activities." Extraction is the collection of revenues by a predating government from its populace to fund other activities of the government, and thus refers to building fiscal capacity. Tilly further theorizes that since before the Modern_state, individuals have displayed powers of "extraction", when individuals plundered each other's villages to extract resources. "Extraction" takes place at different levels of the state--from the beginning of civilization to the modern tax system. A parallel can be drawn to Marcus Olson's theory on roving and stationary bandits, where the start of civilization stems from the incentive of a selfish 'stationary bandit' to capture and extract from a village over an extended period of time.

Since Tilly's monumental theories on war and state-building, his theories have since been reinforced and discussed by political economist studying the connections between military revolutions and state capacity. Herbst for instance extends Tilly's European analysis to explore states in Africa. He finds that while European states have a long history of war and violence which have led to the strong fiscal state they experience today, most African states gained independence without war. Herbst argues that war in Europe pressed governments to "to find new and more regular sources of income" by improving fiscal capacity while incentivizing citizens "to acquiesce to increased taxation...because a threat to their survival will overwhelm other concerns they might have about increased taxation"; he also argues that war inspired nationalism, allowing governments to exact power and collect taxes with greater ease; Herbst then demonstrates that in the absence of war, many African states have lacked these incentives and have thus not been able to increase fiscal capacity.

Nonetheless, studies have also found that despite evidence in Europe, the relationship between fiscal capacity and war does not hold true in South America and Africa.

Legibility and Simplification

In order to build or create what Scott terms a 'modern state', state agents must be able to operate and manage it through processes of simplification, legibility and manipulation. Primary examples of simplification, legibility and manipulation included the creation of standard metric system, in which consistent units of measurements would lead to legible prices and unify populaces to create a homogenous state; a standard metric system, Scott explains, laid the groundwork for additional practices such as centralized administrations and the creation of tax codes. In addition to a unifying measurement system, was state naming and state mapping practices that ultimately allowed states to achieve fiscal goals, to be "revenue rich, militarily potent and easily administered".

He for instance, cites the failed fiscal goals of pre-revolutionary Russian state officials to transform an open-field system in which individuals shared a common property, to independent farmsteads where land was associated with individuals or households. This transformation, he explains, exemplifies state agents' incentives to make the general population "simplified and legible"; for instance, Russian state officials attempted to create a cadastral map, which like a revenue agency, consists of competent administrative agents creating a clear, simple and explicit register of property ownership. However, state officials were unable to achieve this 'legible' regime because the state's power to simplify the state was overcome by the general population's capacity to "subvert, block and even overturn" the state's attempt to standardize its populace.

Along similar lines, in the context of economic development, Besley & Persson explain that fiscal capacity has to do with "deep structural change" that will be "conducive to extracting taxation". Besley & Persson cite the importance of the formal sector and formal financial transactions, stressed by Kleven, Kreiner and Saez (2009) and Gordin and Li (2009), respectively. They specifically demonstrate however, that structural change comes from "mak[ing] transactions more visible to tax authorities". As is such, Scott's emphasis on simplification, legibility and manipulation can otherwise be understood attributing the transition from informal to formal economies as an essential characteristic of understanding and promoting greater fiscal capacity.

As is such, Scott highlights fiscal capacity as the creation of three competing agents--including not only state agents, but also the general population, and local elites.