Trade Negotiations Insights • Volume 9 • Number 6 • July 2010

Why enhance domestic resource mobilisation in Africa?

by Roy Culpeper and Aniket Bhushan

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Developing countries that have achieved and sustained high rates of growth have typically done so largely through the mobilisation of their domestic resources. Domestic resource mobilisation (DRM) at a significant level is essential to solidify ownership over development strategy and to strengthen the bonds of accountability between governments and their citizens. In effect, DRM provides “policy space” to developing countries which is often constrained under the terms and conditions of external resource providers.

Foreign aid comes with conditionality or policy strings attached, not to mention procurement restrictions that accompany “tied aid”. Aid also tends to be pro-cyclical and volatile.[2] Foreign direct investment typically flows into sectors and projects dictated by the commercial interests of the foreign investors - for example, natural resource extraction. Moreover, governments that are heavily dependent on foreign aid, or on sharing the profits of foreign investors, have less incentive to raise taxes and less reason to pay attention to the demands of taxpaying citizens.

It is in Sub-Saharan Africa (SSA) that some of the steepest challenges to DRM are encountered: savings rates are low, dependence on foreign aid is chronically high, and institutional capacity to mobilise domestic resources is weak. In light of these challenges, the North-South Institute recently examined possibilities for enhanced DRM in Sub-Saharan Africa through the lens of five countries: Burundi, Cameroon, Ethiopia, Tanzania and Uganda.[3] These five countries represent a breadth of circumstances in SSA: Burundi is a post-conflict country; Cameroon is experiencing declining oil revenues; Ethiopia is transitioning from a planned to market-based economy; and, Tanzania and Uganda both have longer records of reform and resources revenues (mineral and oil) that are expected to play an increasingly important role.

Pathways to enhanced revenue mobilisation

Most low-income countries (LIC) are heavily dependent on trade taxes as a source of revenue, in large part because they are the easiest taxes to collect. About a third of non-resource tax revenue in SSA comes from trade taxes; however, this figure is in decline (from over 6 percent of regional GDP in the early 1980s to 4 percent by early 2000s). In keeping with global trends, the average tariff rate in the Sub-Saharan region has declined from over 20% in the 1980s to 13% by 2005.

The share of trade taxes in total tax revenue across our five case study countries has been declining. While the overall tax to GDP ratio has increased, it remains far below the Sub- Saharan average at around 18%. The ratio in resource-rich countries is substantially higher at around 25%. Resource-related taxes are responsible for most of the increase in revenue mobilisation in the region (1980-2005).

Tax legislation in most African countries is complex and the tax rules incomprehensible, even to well-educated taxpayers. In many tax codes, a large number of exemptions and derogations exist, representing a staggering opportunity cost in terms of forgone revenue. Exemptions complicate tax systems and open the door to political capture. Too often they are viewed as costless because opportunity costs are not analysed and they are offered on an ad-hoc basis. Once in place, exemptions have a ratcheting effect and are difficult to remove. Despite little evidence that exemptions drive investment decisions, the number of Sub-Saharan countries offering tax holidays, reduced corporate rates, and ‘free zones’ has increased substantially between 1980 and 2005.

The prevalence of exemptions significantly undermines duty revenues. In 2006/7 in Tanzania, import tax exemptions amounted to 32% of total duty revenue. In 2006 in Burundi, 60% of imports were exempted either in part or in full from paying tax or duties resulting in a loss equivalent to 65.5% of duty revenues. In Ethiopia in 2007, customs exemptions amounted to 4.5% of GDP.

Because trade-related taxes are such significant contributors to tax revenues in most African countries, trade liberalisation and tariff reduction measures to encourage greater economic openness should be gradual, paced and sequenced with other reforms aimed at revenue replacement. Aid donors should play a role to this end by pressing their trade negotiators to take a more holistic view of trade liberalisation in low-income countries. As it stands now, that is not happening frequently enough. For example, Cameroon’s Economic Partnership Agreement with the European Union will reduce tariff revenues by 70% or $149 million (equivalent to 0.8% of 2006 GDP). In order not to undermine the revenue base, tariff reduction should be sequenced with the mobilisation of offsetting revenues (VAT or income taxes).

In general, tax systems in Sub-Saharan countries need to be broadened from their narrow base and compliance must be increased. Typically taxes are levied at very high rates on a limited number of wealthy taxpayers, inciting widespread tax evasion and fraud. Lower income tax rates on the wealthy, along with the gradual introduction of income taxes for those less wealthy, are more likely to increase revenue generation and inculcate a more healthy taxpaying culture in the longer run.

Value-added or sales taxes are relatively new to many developing countries, and are likely to be broadened in their coverage and generate more revenue over time. However, there is scope to contemplate the introduction of yet other taxes which are conspicuous by their absence in developing countries. As countries become increasingly urbanized, for example, there is the opportunity to levy taxes on urban properties that are owned and/or which generate rental income. If property taxes were levied and collected, they could support urban and municipal authorities in providing or maintaining infrastructure and other services, including transportation. Research in Tanzania and other countries has repeatedly shown that citizens, including the poor, are willing to pay taxes when they see their taxes work. Property taxes at the municipal level can help engender the virtuous link between enhanced mobilisation and more accountable expenditure, vital to developing taxpayer culture.

In some countries a property tax already exists, in principle, but it is not collected in reality. For example, the annual property assessment in Cameroon’s urban areas is 0.1% of the value of the property, but there is little concerted effort from tax officials to collect this tax or tax on rents. Similarly, property taxes could be strengthened in Tanzania and should be introduced in Uganda.

Reforming tax systems and administrations

As mentioned, in many African countries tax legislation and rules are overly complex. Not only do they encourage evasion, but they also provide too much latitude for discretion and hence corruption on the part of tax collectors and taxpayers. In Uganda, for example, 43% of firms pay bribes to tax officers. For this reason alone tax systems should be simplified and made more transparent.

Looking beyond simplifying and rationalizing tax systems, tax administration capacity and integrity are key to enhanced revenue mobilization. This means elevating the competency of revenue authorities and their officials and rooting out corruption. This is already recognized in the countries we studied. For example, in Ethiopia enhancing the capacity of the revenue authority is a central part of the public sector reform programme. In Cameroon, administrative reforms were introduced in 2004 and the 2007 Fiscal Reform Commission made similar recommendations.

However, there is a sense of déjà vu - such reforms have been introduced in the past and have yet to tackle some of the fundamental underlying problems. For example, in Uganda there has been a series of reforms from 1991-2007, but tax officials still have wide discretionary powers, sometimes abused, and there is widespread tax evasion. Similarly the Government of Tanzania has implemented reforms to strengthen tax administration but there are still extensive loopholes and rampant corruption.

Africans taking ownership over DRM and the role of donors

The global financial and economic crisis of 2008-9 prompted African leaders across the continent to re-examine their economic strategies and vulnerability to external shocks. The crisis has eroded donors’ aid budgets as well as remittances from overseas migrants and export earnings due to the recession in Europe and North America. It is already evident that the OECD donors have fallen short of their aid commitments made at the Gleneagles G-8 Summit in 2005. Only U$11bn of the US$25bn in the additional aid promised for Africa by 2010 will materialize.

African countries have been here before - in periods of prosperity, aid donors make promises they cannot subsequently keep, and rosy forecasts of expanding trade and foreign investment inflows are drastically revised downwards by recession. The current financial crisis has again underlined the vulnerability of SSA to external shocks. However, this time the critical importance and timeliness of enhancing DRM was clearly acknowledged by African finance ministers and central bank governors when they met in January 2009 in Pretoria.

Subsequently, in November 2009 the African Tax Administration Forum was formally launched, bringing together 25 African revenue authorities with a shared conviction that “efficient and effective tax administration is key to building capable states.”[4] The Forum will provide peer support toward increasing the capacity and integrity of African revenue authorities.

While it is appropriate for Africans to play a leadership role, donors can also help. To begin with, they can adopt more coherent policies toward developing countries. In particular their non-aid policies can be made more consistent with their aid policies. Reference was made to the need to slow down and sequence trade liberalisation and tariff reduction in African countries, commensurate with their ability to replace lost revenues in a sustainable manner. Equally, African countries need to review tax incentives offered to foreign investors in their attempts to create a more business-friendly climate. Such incentives often lead to huge and unnecessary tax losses. Better coordination of investment incentives, especially in the context of ongoing regional trade integration such as in the East African Community (EAC), is essential to ensure countries are not undermining one another. If donor countries had a coherent and supportive approach to development, their aid, trade and investment policies would be working together to help build capacity and the self-reliance of their developing-country partners.

Donors can also support African revenue authorities in their attempts to build their capacity. To date technical cooperation to ‘public sector financial management’ in the Sub-Saharan region is only about 2% of total technical cooperation. In our research, we found no significant relationship (positive or negative) between aid levels and tax mobilisation. This suggests there is much room for improvement in support for tax-related capacity building. Donors can provide support in the form of both hardware (information-technology systems) and software (organisational support, skills training and technical assistance, and legal support to make legislation and tax codes more user-friendly and reinforce revenue mobilisation). More importantly, they can help enhance the capacity of domestic policy communities working on taxation. Improving taxpayer education is vital in creating informed bargaining and negotiation around tax issues and central to democratic governance.

While they can make significant contributions to development, external aid or trade and investment opportunities alone will not be sufficient for Sub-Saharan Africa to achieve sustainable, equitable growth and poverty reduction. Development success depends primarily on the efforts of developing countries themselves - which ultimately means enhancing their ability to mobilise their own human and financial resources.

Authors: Roy Culpeper is President, and Aniket Bhushan Researcher, at The North-South Institute in Ottawa, Canada. This article is based on a research project on Domestic Resources Mobilization in Sub-Saharan Africa. More information about this research is available at: http://www.nsi-ins.ca/english/research/progress/58.asp

The authors would like to acknowledge the contributions of the DRM project team through the five country case studies: Tsegabirhan Giorgis Abay (Ethiopia); Astere Girukwigomba (Burundi); Sunday Khan (Cameroon); John Matovu (Uganda); and Nehemiah Osoro (Tanzania). The authors thank Yiagadeesen Samy for helpful comments.

Select Bibliography

Bulíř, Aleš, A. Javier Hamann. Volatility of Development Aid: From the Frying Pan into the Fire? World Development, 36 (10), October 2008.

Culpeper, Roy, and Aniket Bhushan. “Reorienting Development Finance through Enhanced Domestic Resource Mobilization in Developing Countries.” Canadian Development Report, 2009.

Culpeper, Roy, and Aniket Bhushan. ” Domestic Resource Mobilization - A Neglected Factor in Development Strategy.” Project Backgrounder, April 2008. (Online at: http://www.nsi-ins.ca/english/pdf/NSI%20Background%20paper%20DRM%20SSA%20project%20%5B2008%20%5D.pdf ).

Eifert, B. and A. Gelb, A. “Coping with Aid Volatility.” Finance and Development, 42 (3), 2005.

Keen, Michael, and Mario Mansour. “Revenue Mobilization in Sub-Saharan Africa: Challenges from Globalization.” International Monetary Fund Working Paper WP/09/157, July 2009.

Le, Tuan Minh, Blanca Moreno-Dodson, and Jeep Rojchaichaninthorn. “Expanding Taxable Capacity and Reaching Revenue Potential: Cross-Country Analysis - Policy Research Working Paper 4559.” The World Bank, March 2008.

Moore, Mick. “How Does Taxation Affect the Quality of Governance?” IDS Working Paper 280, Institute of Development Studies, April 2007.

[2] Aid is found to be four times as volatile as domestic resources, and aid volatility is greater in more aid dependent countries.

[3] We would like to acknowledge the support of project funders and partners: the African Development Bank, African Economic Research Consortium, Canadian International Development Agency, Department for International Development (UK) and International Development Research Centre (Canada).

[4] For more details on the ATAF launch and communiqués see: http://www.oecd.org/document/55/0,3343,en_2649_33749_44109943_1_1_1_37427,00.html