Effectiveness Of Taxation Structure

Published Date: 02 Nov 2017

Historically, the structure of taxation has been seen and analyzed under the groups of direct and indirect taxation. Most developing countries have relied heavily on indirect taxation, mainly on consumption and other indirect taxes since it is easier to tax consumption than to tax income- a direct means of taxation (Ahmed et al, 2008). In lieu of this, numerous developing countries have opted for excise taxes and tariffs.

On the other hand, indirect taxation such as the Value Added Tax (VAT) has never been so easy to implement for the developing countries. Ehtesham Ahmed and Nicholas Stern of the London School of Economics and Political Science have done a great deal of research over tax issues pertaining to the VAT. Typically, VAT was implemented in the form of Gross Sales Tax in many countries since it was easier to supervise and monitor it within the given administrative expenses. Moreover, with VAT, the coverage of collection is more extensive as compared to income tax because VAT takes care of the shadow economy as well.

Burgess and Stern (1993) yielded a number of useful facts pertaining to taxation. According to them, developing countries, relative to advanced countries, generally tend to rely more on non-tax revenues and obtain a high share of their total tax revenue from indirect taxes (mainly international trade taxes and domestic taxes on goods and services) as compared to direct taxes such as social security contributions and taxes on income, capital gains, payroll, and property (Mahdavi, 2008).

The structure of taxation in a typical developing country such as Pakistan is, characterized by "direct taxes not being paid by those who should be paying them; indirect taxes being largely paid by those who are otherwise considered underprivileged to pay taxes and subsidies and exemptions being cornered by those who should not receive them." The drawbacks for such countries of taxing income include high administrative costs, tax evasion and disobedience to the regulatory law. Other than this, income tax collection has generally been lower in developing countries due to lower income levels where collection at higher marginal tax rate has been minuscule.

2.1.1.1 Effectiveness of taxation structure: a cross country analysis

Mahdavi (2008) studied the structure and composition of taxes over a panel data of countries. The composition of tax structure and its effect on the process of economic development is important for many reasons. First, a given level of taxation may be related with different tax revenue compositions across time and countries. So, even if the level of taxation is taken as "appropriate", its mix may not essentially be "desirable" to the extent that the ‘tax system "overuses" some tax types and "underuses" others’ (2008). Second, possible determinants of the level of taxation are expected to have "differential impacts on various components of total tax revenue." An understanding of the way a change in a specific determinant shifts the composition of tax revenue is vital in designing policies to improve the tax revenue mix. Third, various tax types may differ in relation to their effects on ‘labor–leisure and saving–consumption choices, administrative and compliance costs, the scope for evasion and avoidance, simplicity and transparency, stability, and elasticity with respect to economic growth’ (Mahdavi, 2008). Similarly, at any given level of taxation, a change in the composition of tax revenue may have unusual implications regarding output growth, efficiency, reliability as the basis of revenue stability, depending on the type of tax that caused the adjustment. Lastly, focusing on the behavior of tax level may cover the information regarding the feasibility of alternating revenues from one type of tax for revenue losses in another. Astoundingly, the empirical study of the mix of tax revenue in developing countries are generally limited and limited to description of the differences in the structure of tax revenues between developing countries and advanced industrialized countries.

2.1.2. Tax Administration impacting Tax Effort

A proxy indicator for tax administration is the number of tax payers in the country, which remains significantly low in developing countries, such as Pakistan. As a developing country, Pakistan is of striking importance for its slackening quality of tax administration. Low growth in the number of income tax payers, which remained at approximately two million in a nation of 180 million people, is another crucial reason why the country held a stagnant tax-to-GDP ratio for the last decade, or even more. Also, from about 17000 existing enterprises in Pakistan, only 4000 officially declare taxable income. Statistics reveal a astonishing fact that more than a 100 million cell phone users in Pakistan pay a 10 percent income tax as a rule, but a majority does not file tax returns. Owing to the fact that a lot of tax evasion happens as a result of the rich being outside the tax net or failing to pay income taxes, poverty deepens in society. The poor are overburdened with taxes- mainly including a 16 percent sales tax on the items of consumption as well as being subjected to withholding taxes at source below the income bracket of Rs, 350,000 (Ghaus Pasha, 2010).

2.1.2.1 Role of the Government to increase Tax Effort

There are several drawbacks of taxing income for developing nations, including elevated administrative costs, tax evasion and noncompliance with the regulatory law. Other than this, income tax collection has usually been on the lower end in developing countries due to low income levels where collection at higher marginal tax rate has been very small. Theoretically speaking, a more progressive tax system should lead to the lessening of the extent of tax evasion. Governments have been participating in efforts to increase tax effort. In a typical developing country, such as Pakistan, the government introduced a universal self-assessment scheme (USAS) in the 1990s which, unfortunately, was not accompanied by a fair audit process. This very scheme took tax collections on demand after the audit process, approximating over 20 percent of total tax revenues, which fell drastically to a 10 percent in 2004-05 (Ghaus-Pasha, 2010). Corruption is deepening in the Pakistani society day by day and is a major root cause of a low and almost non-existent tax effort. The People’s Party government under the leadership of Mr. Asif Zardari, has recently announced the cancellation of National Identity Cards (NICs) of those citizens who have not registered or declared their incomes officially to the Federal Bureau of Revenue (FBR) and do not currently hold a National Tax Number (NTN). Such efforts on the part of the government will produce results with a huge time lag and its efficiency might be put under question.

The way forward in order to improve tax revenue collection and management is the government’s implementation of a proper resource mobilization plan in any nation of the world, which should have various aspects to address such as the development of the existing General Sales Tax (GST) to cover the exempted sectors of the economy, typically in the developing world; improvement in the regional tax- to-GDP ratio by improved quality of tax administration and considerably less prospects of tax evasion; and an expansion of direct tax or the income tax administration. These changes will lay the path into bringing any country out of low tax revenue trap. However, the political will of the country’s leadership is a critical factor in order to bring further improvements in tax administration, adjustment and implementation of sound rational tax policies and the promotion of higher tax compliance by the citizens of countries.

Deborah Brautigam (2009) consolidates the political economy theories of taxation, which stress on elite dominance and ethnic division and would very well be useful in explaining why growth in developing countries cannot be translated into development and higher tax revenues. Let’s take the case of Pakistan, again, for reference. The rural areas of Pakistan are notorious for being dominated by large ‘feudal’ landowners. Such landowners have been outstanding and influential in almost all Pakistani government coalitions is a rationale as to why fiscal efforts have been resisted, especially in agriculture. Their power and influence was so great that they were long able to obstruct direct taxation of agricultural income, depriving the nation of a major revenue source. These landowners had formed a coalition with the military leadership under the Musharraf regime (1999-2008), too, and have over time played an important role in Pakistani politics.

Moreover, the economists and academics within the governments may also resort to econometric modeling and other mathematical techniques over the national data to ensure tax compliance. Using a data mining technique over a panel of countries, Wu et all (2012) develop a "screening framework to filter possible non-compliant value-added tax reports that may be subject to further auditing. The results show that the proposed data mining technique truly enhances the uncovering of tax evasion, and can be employed to effectively reduce or minimize losses from VAT evasion."

A crucial effort on the part of the public sector, again, is required when it comes to bringing large underground economies to documentation within the developing world. With the expansion of informal sector in the developing economies and government's futile efforts to increase the revenue collection from this very sector, the importance of taxing informal sector has become even more crucial. Various advisory and regulatory organizations have stressed to focus on the tax payers in the formal sectors, with the expectation that VAT or other indirect taxes will eventually swallow up the informal sector (Tanzi and Zee, 2001). Nevertheless, the importance of taxing informal sector should remain the core of the tax system to avoid the formal sector bearing the brunt of tax regime individually and to increase the accountability in relationship with taxation for a sound, healthy economy.

The most apparent reason as to why it is difficult to tax informal sector is the nature of the sector itself. Informal sector has a multifaceted structure with large number of diverse operators involved in it. Most businesses are carried out at homes which remain undocumented and difficult for the authorities to keep an eye on. Moreover, lack of illiteracy means less trust in banks and more hard cash dealings. Amidst these grave issues, the government finds it cost-ineffective to allocate the essential resources for taxing informal sector. Not only this, some countries do not have the capacity or the resources to carry out thriving revenue collection in this sector (Joshi and Ayee, 2008). Furthermore, in places with feudalism, especially in South Asia, and parallel government structures, in African Countries for example, where many non-state actors exist, the incentive to tax informal sector is even lower. Tax officials find it unrewarding and sometimes life-threatening to carry out their activities in these circumstances. Hence, it is safe to say that taxation involving the underground economy is very challenging, and so is dismal on the part of many developing countries, such as Bangladesh, to lack a hike in annual tax revenues, which would otherwise have been possible.

2.1.3. International Tax Effort Models

Tax effort models have been viewed as providing a policy maker with a normative, somewhat monotonous, prescription concerning the appropriateness of a country’s tax rate. So to say, the tax effort model has been used to suggest whether a specific country has a low or a high tax capacity and tax effort, relative to other countries (Clyde Taylor, 1979). In a tax effort model, it is important to explain only those variations in the share of taxes which are due to taxable capacity factors in a multiple regression equation. The few main models include the Lorz and Morss Model, The UNCTAD model, the Bahl model and the Fiscal Decision Maker model of tax effort.

2.1.3.1 Lorz and Morss model

The Lorz and Morss tax effort model (1967) represent an addition of state and local tax effort models to cross-country comparisons. It attempts to explain those factors measuring a country’s taxable capacity in order to determine a country’s tax effort.

2.1.3.2 UNCTAD model

The United Nations Conference on Trade and Development (UNCTAD) model (1970) differed from the Lotz and Morss model in that it pooled cross-section and time series data. A crucial assumption made was that those factors which determine taxable capacity cross-sectionally also determine taxable capacity over time.

2.1.3.3 Bahl Model

The Bahl model (1971) summarized many of the previous tax effort models, examined their differences and came up with a tax effort model that dealt with some of the main methodological and theoretical problems related with the tax effort approach. Bahl noted that three main determinants of tax effort are the crucial ones: the relative productivity of public versus private investments; a desire of the government to intervene in the resource allocation procedure for distributional reasons; and historical institutional arrangements for particular activities between public and private sectors. The three variables measuring taxable capacity in his model are the stage of development, the size of the foreign trade sector, and a measure of the sectoral composition of value added.

2.1.3.4 Fiscal decision maker model

In the fiscal decision maker model, the concept of a country’s taxable capacity is the tax share generated by the general adaptation of fiscal decision makers to expected changes in the socioeconomic environment in which they act. Tax effort is envisaged as deriving from specific country differences in the socioeconomic environment to which the fiscal decision maker can adapt to some degree. Political survival as his primary goal, the fiscal decision maker chooses the taxes and social good expenditures that enhance the probability of his reelection or reappointment. In this new tax effort model, the level of development variable becomes a proxy for the network of changes in tax resistance while the openness variable becomes a proxy for the cost of tax administration. So, tax effort is determined by the willingness of the fiscal decision maker to utilize taxable capacity.

2.1.4 Indicators and instruments of assessing tax effort

‘Tax effort’ is the "index of the ratio between the share of the actual collection to GDP and the expected taxable capacity. A tax effort of above 1 - high tax effort- implies that the country utilizes its tax base well to increase revenues (Stotsky, et al. 1997). While on the other hand, a country with the tax effort below 1, implying low tax effort, is likely to have relatively considerable scope or potential to increase revenues. The concepts of taxable capacity and tax effort can be further extended to measure ‘fiscal revenue capacity’ and ‘fiscal revenue effort’. Total fiscal revenue consists of both tax and non-tax collection; it represents cash receipts from taxes, nontax sources such as fines, fees, rent, and income from property or sales and the size of the foreign trade sector. Selecting the methodology used to estimate and interpret the tax effort index is a point of caution. The computation of the index is sensitive to the expected results of a country’s taxable capacity (Minh Le et al, 2008).

Stotsky and WoldeMariam (1997) examined tax-to-GDP ratio as a proxy for tax effort, which is defined as total government tax collection divided by the country’s GDP. The actual tax to Gross Domestic Product ratio is usually interpreted as a measure of tax effort and used as the basis for cross country tax comparison. The use of such ratio seems reasonable if attempted to establish trends or to compare tax revenue performance across countries with comparable economic structure and at the same level of income. The advantage of using this approach is that it is simple and provides a quick overview of the trends of the international tax collections. However, when used to evaluate the effectiveness in revenue mobilization across countries in various income groups, the tax-GDP ratio could provide a ‘completely distorted’ picture because of the different economic structures, institutional arrangements, and demographic trends of the countries (Prest, 1979). In such circumstances, this ratio does not reflect the tax potential or capacity of a country, making it impossible to assess whether or not a country is out of line in assessment with its peers in its effort to increase domestic tax revenues.

Tax base availability, which is an interpretation of tax capacity again, shows the predicted tax-to-GDP ratio estimated from a regression, while taking into account country’s specific characteristics. These have been indicators in literature for tax effort that the four models previously discussed above have been used for further analysis. Every model uses its own different definition of taxable capacity and the economic assumptions that come with it. Traditionally, indictors of development were used to measure tax effort. For example, in the later Fiscal Decision-Maker model, tax effort is determined by the willingness of the fiscal decision of the fiscal decision maker to maximize taxable capacity (Clyde Taylor, 1979). The different approaches chosen by Lotz and Morss, Bahl and the later tax effort models can be seen as deriving from their varying buoyancy showing that there exists a pattern of development in relation to tax structure for least developed countries.

Chelliah et al. (1975) emphasize the fact that tax effort indexes are not solely intended to be applied in a mechanistic manner ‘but rather to be considered useful additional information in judging the scope for more taxes’ (1975). Tax effort as a variable cannot be a replacement for a comprehensive study of taxation in relation with the need for and composition of public expenditures of any particular country.

2.2 Defining and Measuring Foreign Aid

Foreign aid and foreign private investment are two important sources of capital for developing countries. Foreign Aid can be categorized into grants and low interest rate loans. The last three decades have observed important changes in the trend of such foreign capital flows from the developed to developing countries. Foreign aid to developing countries increased from US$1.9 billion in 1970 to US$27.1 billion in 1998 (Ghaus Pasha, 2010).

Source: Hang Le, Ataullah, 2006

2.2.2 Evolution of Foreign Aid

Foreign aid has been an important source of foreign capital for many developing countries, especially during the 1960s, 1970s, and 1980s. Initially, being an important economic bloc, the USA strategically started its first foreign aid program in the early Cold War. It demonstrated the nation's assumption of their new economic and political role, as represented by the Truman Doctrine and its support to former British clients as Greece and Turkey. The United States also used foreign aid to give rise to free-market standards for development, the integration of West European economies and the limitation of economic protectionism, through instruments such as the Marshall Plan. It was thought that these programs would greatly benefit the U.S. economy by giving orders at home. Most importantly, such efforts were designed to thwart the spread of international communism, since in early 1946 the U.S. policymakers started becoming convinced that the Soviet Union was aiming towards word domination.

Foreign aid has always been an important source of capital for many African and Asian countries. Pakistan, especially during the 1960s and 1970s, was one of the largest aid recipients in Asia. In the 1980s, Pakistan received large foreign aid flows due to its front-line role in the American-Russian conflict over Afghanistan. These aid inflows, which reached US$2 billion annually by the mid-1980s, are claimed to have supplemented already inadequate domestic savings and foreign remittances, and increased the credit worthiness of Pakistan (Husain, 1999).

The end of the Cold War, which has lessened the strategic importance of foreign aid, has led to a decline in foreign aid during the 1990s. Although the amount of aid has declined, the number of aid agencies has increased from about 7 in 1960 to about 50 in the 1990s. The multilateral organizations, such as the World Bank (WB) or the International Monetary Fund (IMF) have taken a somewhat eminent authority over the economic policies of developing countries. These agencies impose strict conditions on the recipient countries and intimidate them to withdraw aid if the conditions are not met. Foreign aid, to some extent, has helped to promote growth and structural transformation in the recipient countries, especially at the time of post-war reconstruction and natural disasters. It is, however, widely argued that the impacts of foreign aid on development are limited because foreign aid is usually directed towards military and political fields instead of human development (Hang Le and Ataullah, 2007).

2.2.3 Types and nature of foreign aid

Foreign aid has an extremely diverse and heterogeneous nature. We cannot give a single figure to it and analyze the whole situation based on just one figure (Mavrotas, 2002).

2.2.3.1 Sources of foreign aid

At least four different categories of aid are presented in literature: "project aid with a rather lengthy gestation period, technical assistance, and food aid and other commodity aid which adds directly to consumption." To these four types of foreign aid, emergency or relief aid could be added as a distinct category, given its rising importance in recent years (Mavrotas, 2002).

2.2.4 Theories and models of foreign aid in literature

2.2.4.1. The dual gap model

A theoretical model of foreign aid in literature is the dual gap model. The Dual-gap theory emphasizes the role of imports and foreign exchange within the development process. The characteristic contribution of the dual-gap analysis is that though foreign exchange is the leading constraint, it points to the dual role of foreign borrowing in increasing not only scarce domestic saving but also foreign exchange. It is evident that domestic provision requires domestic saving; and that foreign provision of goods requires foreign exchange. There is always a need for a minimum amount of foreign exchange to sustain the growth process. The model takes both the traditional and modern view on foreign assistance- as a boost to domestic saving and, on the other hand, import of goods necessary for growth with the aid of foreign assistance. The dual-gap analysis also presents a more relevant theory of trade for developing countries which justifies protection and import substitution (Ahmed, 2001)

2.2.4.2 The foreign exchange gap

The foreign exchange gap is defined as the deficit on the country’s current account where the balance of payments exceeds the capital inflows. The foreign exchange gap is a concept very pertinent to developing countries. They are usually characterized as being short of capital, since their saving and investment rates differ from developed nations. With external aid and other forms of monetary assistance, developing and underdeveloped countries can get initial capital required to embark on the pathway to industrialization. Once industrialization is underway, the problem of domestic saving resolves gradually. The two gap model is based on the assumption that for developing countries to maintain high growth and industrialization, foreign currency is needed to import capital equipment, raw materials and intermediate goods. Thus foreign exchange gap can become a big development constraint.

Hence, recipient countries may require foreign aid in order to cater to their foreign exchange gap.

2.3 A review of the demand and supply side factors of foreign aid

2.3.1. Demand side factors and the three gap model

As opposed to macroeconomic growth models of full employment, the three-gap model unambiguously considers the interplay between ‘capacity expansion and capacity utilization’. In addition, less data requirement of the model makes it well-suited to countries such as China and Pakistan, where the reporting, coverage and accessibility of time series data is very limited. Gap analysis assumes that the incremental capital-output ratio and other behavioral indicators are fixed in the medium-term and that there is restricted replacement and substitution between domestic and foreign resources.

According to the three-gap model, the expansion and utilization of current productive capacity is constrained by not only the domestic and foreign savings, but also by the impact of fiscal limitations on government spending and hence on its public investment choices (Zhang and Chen, 2006).

2.3.1.1 Motives of Recipient Countries of Foreign Aid

Many recipients receive aid from at least some OECD donors annually. Recent research suggests that corrupt recipient governments, especially of the developing world, have incentives to comply with donor objectives in the public health sectors but they will do so in aid sectors, in which compliance is less costly. This strategy allows corrupt recipients to achieve at least some developmental tasks successfully, hence justifying additional aid inflows (Dietrich, 2011).

2.3.1.2 Policies of recipient countries regarding foreign aid

Many developing nations experience a phenomenal debt burden in lieu of the increasing tendency towards providing loan-type aid instead of grant-type aid and also towards tying aid to the exports of donor countries. Given the ambiguous effects of foreign aid and limited control over the amount of aid received, policy makers in developing countries have started seeking substitute sources of foreign capital i.e. foreign private investment- foreign direct and portfolio investment.

Also, the conditions imposed by aid agencies such as IMF and World Bank, may lead to limitations on policy autonomy of the recipient country and become influential in dictating governments of recipient countries. Empirical evidence suggests that foreign aid has not contributed intensely to the economic growth and development of recipient countries and it has even amplified inequalities among different groups (Hang Le and Ataullah, 2011). Many studies even suggest that aid has the potential to delay the timing of important reforms by providing additional resources to vested interests that persuade authorities of the recipient country ‘to resist adjustments and delay the day of reckoning’ (Casella and Eichengreen, 1996).

2.3.2. Supply side factors

2.3.2.1 Determinants of donor’s aid allocation policies

The increasing tendency toward providing loan-type aid instead of grant-type aid and toward tying aid to the exports of donor countries is a way of the donor to increase the debt burden of the recipient country so that it becomes economically dependent on it for servicing its debt (Le and Ataullah, 2011). Aid agencies, such as IMF and WB, have become more influential in dictating the governments of recipient country in their own strategic interests.

Bermeo (2011) uses data from the AidData project to analyze the relationship between foreign aid and the possibility of democratization in aid recipients. According to him, the association between aid and democratization depends on characteristics of the aid donor. During the period 1992 to 2007, aid from democratic donors was found to be linked with an increase in the probability of a democratic transition. It suggested that democratic donors use scarce aid resources to encourage democracy. However, during the same period, aid from authoritarian donors shows a negative relationship with democratization. Authoritarian donors are doubtful to include democracy promotion in their objective function when determining aid policy. China also places low conditionality on its aid and does not prioritize democratization.

Examining the websites for the Abu Dhabi Fund for Development, the Kuwait Fund for Arab Economic Development and The Saudi Fund for Development confirms that problems of governance are not listed as big priorities for these donors. The Saudi Fund clearly states that loans are made without conditions and the Fund deals directly with governments of the developing countries in financing developments projects, providing direct evidence that it does not follow new ways of channeling of aid that many OECD donors use. It is possible that any differences observed between democratic aid and authoritarian aid in their association with regime change is driven by the choice of recipients to a great extent.

Balla and Reinhardt (2008) have another viewpoint. They find that donors have responded to balanced incentives to decrease recipient poverty and further donor political and economic goals. Every bilateral donor conditions aid on conflict. The U.S. allocates huge amounts of development aid to countries bordering a conflict, in both pre- and post-Cold War times. However, controlling for development levels and donor economic and political interest, ‘most donors reduce aid to a recipient with an in-house or nearby intense conflict’ (Balla and Reinhardt, 2008).

It is seen that most western donors give substantial amounts of foreign aid to corrupt countries. While this might suggest a policy failure to some, it may well be indicative of donor practice that is often overlooked in literature: recipient governments’ ‘good behavior’ in foreign aid sectors, irrespective of their poor national institutions, matters for allocation. ‘When evaluating the high fiduciary risks associated with spending money on the world’s poorest and often most corrupt countries, donors look for specific sector-related progress’ (Dietrich, 2011).

2.3.3 Politics and geopolitics of foreign aid

2.3.3.1 Geopolitics and foreign policy

Many democratic aid donors state democracy promotion as a foreign policy goal. The United States Agency for International Development (USAID) claims that "our work supports long-term and equitable economic growth and advances US foreign policy objectives by supporting: economic growth, agriculture and trade; global health; and, democracy, conflict prevention and humanitarian assistance." The United Kingdom’s Department for International Development (DFID) created the Governance and Transparency Fund to address issues such as "the ability of citizens to make their voices heard and hold their governments to account." Japan’s Official Development Assistance Charter states that "preventing conflicts and terrorism, and efforts to build peace, as well as efforts to foster democratization have become major issues inherent to the stability and development of the international community" (Bermeo, 2011).

2.3.3.2 Geopolitics and foreign aid

Tingley (2009) uses a time-series cross-sectional data set to examine the influence of changes in political and fiscal variables. According to him, as governments become more and more conservative, their aid effort starts to fall. Domestic political variables emerge to influence aid effort, however, only for aid to low income countries and multilaterals as compared to aid effort to middle income countries which remains unaffected. This emphasizes donor economic and international strategic interests as reasons of donor aid policy may be misjudged. His results also suggest foundations of aid volatility that might pressure recipient growth prospects (2009).

2.3.3.3 Governance and its relation to foreign aid

Burnside and Dollar’s (2000) study introduces governance into the effectiveness of aid debate. They analyze the fact that aid increases overall economic growth in the recipient country, provided it is used optimally with good governance practices and fiscal and monetary policies. They shift their focus from policies to institutions, finding empirical support and evidence for a multiplier effect of good governance.

The focus of research aid effectiveness is the conditioning effect of political institutions. Kosack (2003) also looks into the conditioning effect of democracy but adds the aspect of human development to it too. He shows that more democratic governments are more efficient at channeling aid by improving peoples’ lives, as calculated with the Human Development Index (Dietrich, 2011).

Recent research suggests that corrupt recipient governments, especially of the developing world, have incentives to comply with donor objectives in the public health sectors but they will do so in aid sectors, in which compliance is less costly. This strategy allows corrupt recipients to achieve at least some developmental tasks successfully, hence justifying additional aid inflows (Dietrich, 2011). This implies huge loopholes in good governance by recipient countries.

There are examples that state otherwise. Good governance practices can be found in corrupt recipient countries too. Bangladesh, which ranks among the world’s most corrupt countries by Transparency International (2006), received US$ 833 million in foreign aid in 2006, of which only US$ 170 million was health-related aid. Despite extremely high corruption levels, the country has shown notable success over the last couple of years in improving the condition of basic health services. Donor representatives appreciate Bangladeshi collaboration in addressing essential needs of their citizens, particularly on child health outcomes. Whether a country is receptive to the donor’s calls will have an effect on the nature and size of foreign aid.

Similarly, Mali, which is also seen as a corrupt country recently received a positive mentioning by an OECD health aid assessment (2009), but accomplished very little in other sectors. Targeted and sustained immunization, special government programs to reduce pneumonia-related deaths, national awareness campaigns on the treatment of diarrhea, better sanitation, and better access to safe water. For theories of aid effectiveness focused on the quality of governance, such stories might appear inconsistent. The high corruption scores should mean that Bangladesh’s government would direct substantial amounts of public health aid for private gain and less to leave aside for development purposes (Dietrich, 2011).

There is growing agreement that aid transparency and good governance must be improved to get better aid effectiveness. Aid transparency can be defined as "the comprehensive availability and accessibility of aid flow information in a timely, systematic and comparable manner that allows public participation in government accountability" (Ghosh and Kharas, 2011). Greater transparency helps donor nations to evaluate their aid programs more efficiently.

Some countries, such as the US, provide aid through multiple agencies, often with overlapping responsibilities. The result is a confusing replication of activities and diffuses accountability.

‘Greater transparency is necessary for recipient country citizens to be able to hold their government accountable over any discrepancies between aid received and aid spent. For example, in Afghanistan, an official at the Ministry of Finance when interviewed by Oxfam America said that since 2001, the US had pledged $32 billion in aid but less than 20% ($6 billion) was recorded in the government databases. This means that Afghans have no way of knowing what happened to the other $26 billion that the US could have spent in their country. 18 With greater transparency of how much aid is coming into their country, citizens and government officials can have a greater say in how best to use the funds’ (Ghosh and Kharas, 2011).

2.4 Foreign aid inflow, tax reforms and tax effort

2.4.1 Aid effectiveness on tax effort

The relationship between aid effectiveness and tax effort can be highlighted using the case of Pakistan as a typical developing nation. During the 1960s, 70s, and 80s Pakistan was among the largest aid recipient countries. But the benefits of this aid have not stretched to the whole society, especially in areas of fiscal revenues. Foreign aid failed to induce the government to develop a sound education standard for the country. Though the country received huge foreign aid inflows during this time, the illiteracy rate in Pakistan remained almost unchanged (around 59-65%). While other Asian countries, like Malaysia or Sri Lanka that received only US$2.4 and US$3.9 per head of aid in 1970, respectively, were successful in improving the literacy rates significantly. Other indicators, like employment and health, present the same depiction.

2.4.2 Composition of aid and tax effort

The composition of aid and tax effort can be clearly related through the example of Pakistan. The USA has been Pakistan’s biggest donor of economic and military aid. Hence for simplicity purposes, the figures for US aid will be considered in the analysis. Official figures reveal that for more than 50 years, the US has given Pakistan a sum of $33.606 billion in economic and $8.932 billion in military assistance. For the 32 years of military regimes that the country has had, Pakistan received a total of $24.993 billion in economic assistance and $6.646 billion in military aid. This is in contrast with the democratic regimes, where US aid under these categories summed up to $8.612 billion and $2.286 billion, respectively (Ali, 2009).

A snapshot of the military and economic assistance from the US to Pakistan under the period of research is presented in the graph below where we can clearly see the sharply rising trend of military aid in relation to economic aid.

2.4.3 Foreign aid and its impact on tax revenue and tax effort

‘Foreign aid’ is taken here as both the official and unofficial loans and grants given to the country by various bilateral and multilateral sources. It is claimed that the government’s expenditure and revenue efforts are influenced by foreign aid which are channeled through by a reallocation within the broad categories of public expenditures and income (Ahmed at al, 2009). The generally accepted impression is that foreign aid will reduce revenues from taxation in the recipient country (Sharif and Munir, 2010). The rise in foreign resource inflow embarks the government of developing countries on the path of complacency. This was the case of the military regimes of the country especially, where the fear of political reactions from citizens, influential bureaucrats and cronies barred them from decisions on domestic resource mobilization.

In economic development and political economy theory, we see that the governments which are hugely dependent upon ‘earned’ revenues such as taxes, as opposed to frequent ‘unearned’ revenues such as aid or mineral wealth, are highly likely to be receptive and accountable to their citizens. Vice versa also hold true; citizens who pay taxes are more demanding of responsive governments (Joshi and Ayee, 2008).