This paper is prepared for staff SAIDA~<2use and is not for publication SW r P43 The views expressed are those of the author and not necessarily those of the Bank. Public Disclosure Authorized INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

INTERNATIONAL DEVELOPMNT ASSOCIATICN

Economics Department Working Paper No. 43

TAXATION AND EARMARKING IN D f E & D April 1, 1969 SEP 2 1 8

INTERNAIONAL BANKrOR This study of earmarking OR V9T.OP*aper on "The Earmarking of Taxes for SrlnoAa5y In Develop-

Public Disclosure Authorized ing Countries", (Economics Department Working Paper No. 1). The limited objective of this paper had been to establish enpirically whether any relation- ship appears to exist between earmarking and a higher relative expenditure allocation for highways than in the absence of earmarking. The present study is much wider. It makes an overall evaluation of earmarking in developing countries in which the findings of the highway study have been incorporated. The analysis is theoretical but is supported by empiri- cal studies. It focuses in particular upon the relation- ship between earmarking and certain crucial problems of public expenditure determination as they arise in

Public Disclosure Authorized developing countries (e.g. political decision-making, bureaucratic inefficiencies, the undesirable growth of non-development expenditure, etc.). I am indebted -9 \ g in particular to Stanley Please, Chief of the Fiscal Policies of Developing Countries Division, for helpful WBG comments throughout this study and also to my other colleagues, especially John Holsen. In the IMF, both Leif Iliuten and Joergen Lotz have taken their time to discuss with me the findings of the study. I have also received valuable suggestions from Dr. Charles J. Goetz of the Virginia Polytechnic Institute. How- ever, I am solely responsible for this draft.

Fiscal Policies of Developing Countries Division

Public Disclosure Authorized Prepared by: Per Eklund Assisted by: Rosalinda Dacumos TAM,E OF CONTENTS

Page No. SUMMARY (i vi)

CHAPTER I EVOLUTION OF EARi4ARKING 1

-- Introduction 1 -- Literature 2 -What is an earmarked tax? 4 -Types of earmarking 5 -Insulation of revenue 5 -The tax base - earmarking versus general fund 6 -Developed countries 6 -Developing countries 7 -Earmarking and degree of social and economic development 7

CHAPTER II BUDGET POLICY AND EARAA.RKING OF TAXES 9

-Targets of budget policy 9 -The benefit of theory of taxation 10 -Satisfying collective wants 11 -The Lindahl theory 13 -User charges 14 -Annex Chapter:-II

CHAPTER III COiPARISON OF AN ACTUAL SYSTEA OF PARLIAAENTARY DEMOCRACY WITH THE LINDAHL THEORY 16

-Individual evaluation 16 -Reflections of individual Preferences in political programs 18 -Accommodation of minority and special interests under majority voting 18 -Number of groups 18 -Voting and legislative procedures 19 -Correction of divergences 19 -Costs and benefit evaluation of public expenditure 19 -Separation between basic and appropria- tions legislation 20 -Unstable majority coalitions 21 -i4inority groups 22 -Time dimension 23 (ii)

TABLE OF CONTENTS (Continued)

Page No.

CHhPTER IV THE LINDAHL THEDRY APPLIED 24

-Summary 24 -Developing countries 26 -Unstable majority coalitions 27

CHAPTER V TWO SPECIAL CASES 29

-Earmarking and Local Government 29 -IMlustrations 30 -Foreign Aid 31

CHAPTER VI BUDGETING UNDER INEFFICIENCY 33

-Political interference 33 -Administrative inefficiency 34 -Remedies - the role of earmarking 34 -A bias against developmental goods and services in the budget making? 36 -Earmarking promotes the development effort 38 -The bureaucracy - To reach agreement to shift to earmarking? 38 -Savings through taxation - A reality or mirage 40 -Annex Chapter VI

CHAPTER VII EARKA9RKING FOR HIGHW4AYS IN DEVELOPING COUNTRIES - AN EAPIRICAL STUDY 43

-3urvey results 43 -Earmarking and non-earmarking countries -- Cross section analysis 44 -Earmarking countries 45 -Time series analysis 46 -Countries which initiated or discontinued earmarking 47 -Summary of findings 48 -Explanation of findings 49 -A new theory of the budgetary process 49 (iii)

TABLE OF CONTENTS (Continued)

Page No.

CHAPTER VIII BENEFITS VERSUS COSTS OF EARARKING 53

-Budget rigidity 53 -Periodic re-evaluation of the earmarking arrangement 54 -Statutory versus constitutional earmarking 57 -Betterment levies 57 -Earmarking for maintenance or for investment 59 -Program and performance budgeting and earmarking 60 -Survey 62 -Earmarking and short-run demand control policy 62

CHAPTER IX ELMRMARKING IN THE PHILIPPINES - A CASE STUDY 65

-Revenues 65 -Unstable majority coalitions 66 -Political interference 66 -Administrative inefficiency 66 -Earmarking for eco mmic development 67 -The highway special fund 70 -New Tax program 71 -Conclusion - Philippines 71 -Recommendation 72

CHAPTER X CONCLUSIONS 73

-M

TABLE OF CONTENTS (Continued)

ANNEX I DECISION i4AKING IN A PARLIAKENTARY DENOCRACY -- K.kJORITY VOTING

ANNEX II EA.RARKING FOR HIGHWAYS IN DEVELOPING COUNTRIES

-Statistical tests

ANNEX TO CHAPTER II THE THEORY OF SATISFYING COLLECTIVE WANTS

-The Lindahl theory -How to reach the equilibrium -Benefit allocation versus redistribution equity considerations -Revelation of preferences -A more realistic model with two public goods -Group behavior under voting - A majority rule budgetary model

ANNEX TO CHAPTER VI CHANGES FROM GENERAL FUND TO EARMARKING -- A THBERETICAL ANALYSIS

-Reduction of unit costs -Change in budgetary ratio

REFERENCES The motivation for this study within the Bank came from two directions. At the operational level, we have been concerned that the Bank has been in danger of a schizophrenic attitude on the desirability of earmarking as a fiscal device. Whilst at the macro level of fiscal policy discus3ion there has been a widespread (though not universal) ten- dency to deplore earmarking, at the project level the Bank has concurred with, encouraged and even insisted on the earmarking of government funds. Secondly in trying to bring to bear upon this operational question, the findings of analytical and empirical study to be found in the literature on public finance, we have been surprised to find how little attention students have given to this precise issue. Thus a need has arisen to help fill part of this gap in our basic knowledge.

The study sets out to explore more fully the widespread dislike of earmarking by many students of public finance. The basis for this dislike is quite simple. It merely states that earmarking imposes a constraint on the rational allocation of a given volume of government funds to different func- tions, regional groups, etc. and as a consequence prevents the implementation of a flexible budgetary policy for maximizing society's welfare. It is analogous to a constraint which prevents a person consuming out of his given income a bundle of goods and services such that the weighted marginal utility of each component of the bundle is equal. Just as individual welfare is maximized by ensuring that this optimum expenditure pattern is achieved, so society's welfare is maximized by ensuring that marginal allocations of budgetary funds can be so adjusted that the last unit of money spent in all directions gives the same utility.

In effect what this study emphasizes is that this conventional attitude towards earmarking is based on analysis which is not only simple but also simplistic. In doing so it does not reject the dangers which arise from a misallocation of resources due to earmarking. On the contrary, it is emphasized that this is one of the major elements in the trade-off exer- cise which has to be undertaken to determine the desirability of earmarking in any particular case. However, the study argues that the process by which both the level and pattern of government expenditures are determined is far more complex in both conception and execution than is implied by an analogy with a housewife spending the weekly household income on food, clothing, luxuries, etc.

To begin with, in conception this analogy is largely irrelevant. Except in the most dictatorial of political regimes, no single preference function exists. Society is a complex organization in which group interests rarely coincide and thus the process by which political decision-making comes about is crucial. Theorists and practitioners in the field of public finance typically ignore this complexity and more typically still, external observers and advisors on national tax policy analyze and prescribe with virtually no - ii - recognition of the problems arising out of the decision-making process within a particular country. This study has pursued the decision-making process more fully. In doing so it has drawn heavily upon the work of Erik Lindahl.l/ This theory deals with the analogy between budget determination in the public sector and price formation in the market for private goods and services. As such it draws out more explicitly the view of NIusgrave 2/ and others that: "'....the inter-relation betwfeen the tax (cost) and experiditure (benefit) side of the budget is the essence of fiscal economics and that a theory of taxa- tion distinct from that of expenditures has little meaning." To Lindahl the central issue is the need for a simultaneous consideration of the level and pattern both of taxes and of government expenditures if an optimum allo- cation of resources is to be achieved. In this context a specialization of the budget with the earmarking of taxes assumes great importance.

Needless to say, there are major gaps between the tax-expenditure decision-making process constructed at the theoretical level by Lindahl and others, and the real world (though these gaps are probably less than in many other parts of public finance theory). There is to begin with the problem of achieving or assuming an equitable distribution of income; secondly there is the question of whether, and if so how, individuals and groups reveal their pre,erences for public goods and services; thirdly difficulties regarding the manner in which they can evaluate the benefits of public expenditure; fourthly the question of the extent to which party political programs and actions reflect group interests; and finally the procedures and rules of voting in legislatures including the problem of accommodating a large number of groups and, in particular, of dealing with minority groups. The signi- ficance of each of these factors and particularly their significance, from the point of view of the desirability of using the earmarking device, will vary.

In particular the importance of earmarking will vary, with the com- plexity of the socio-political process. As already noted, at one end of the spectrum, if there is a political dictatorship or a highly unified society (as, perhaps, during a war), then earmarking to achieve a national allocation or resources might be unnecessary. At the other extreme, if a country comprises numerous interest groups (geographical, economic, etc.) between whom little confidence exists that understandings on tax-expenditure policy matters will be honored, then a high degree of earmarking will be essential i~ agreement is to be reached on such policy matters. This is the problem of unstable majorlty coalitions and it is fundamental in discussing ear- marking in the developing countries. The study argues that on both a priori grounds and on the basis of historical and current observations, that at an early stage of economic development a society is more likely to be hetero- geneous and fractionalistic than at a more advanced stage of development. This appears to be true particularly in the countries of Latin America and in such countries as the Philippines.

What is most obvious in this regard, however, is the political and social fragmentaticn of the international community. If there were un- animity of objectives and priorities amongst national governments, then under-

1/ See p. 16 below.

2/ See p. 1 below. takings to tax the rich countries to provide aid to the developing countries to assist their own development efforts could and would be entered into with- out the use of earmarking. In fact, of course, we find that earmarking is widespread in international tax-expenditure relationships whether these are bi-lateral or multi-lateral relationships. Before they are willing to undertake their side of a foreign assistance agreement, aid givers require assurances that local matching funds for prescribed purposes will be made available in the volume and at the times which are agreed. The tying of the assistance itself to precise projects and sectors is a reflection of a similar lack of confidence between nations even when acting through an international agency. The inefficiencies which can arise from such ear- marking are well recognized. It is equally recognized, however, that the flow of foreign assistance is likely to be considerably below its existing level but for such earmarking arrangements. The World Bank is in this context simply one pressure group which is attempting in a world of conflicting objectives to ensure a greater flow of resources to the development of the poorer countries by providing the taxpayers and their representatives with formal agreements rather than informal understandings that increased tax revenues will flow into development rather than into the satisfaction of other national ends.

This lack of political and social cohesion at the international level is different only in degree from that found at the level of some national states. There is in fact a continuum from the international state of affairs in this regard through countries of ever increasing degrees of unity in social and political action. Thus it is irrational to jump from a willingness to accept the need and desirability for ear- marking at the international level to an unwillingness to countenance its use under any circumstances at the national level. What one would expect, and what one in fact observes, is a wide variation in the use of earmarking from one country to another. As already observed there are reasons to believe that these variations are primarily a reflection of the homogeneity of the community or its lack thereof.

It should be emphasized that whilst in part this study is a piece of positive economics which attempts to explain reality - i.e. why the earmarking of revenues is adopted in certain countries and not in others - it is also normative. In this latter regard it argues that under certain social and political assumptions, a more optimum level and pattern of government expenditure will arise if earmarking is adopted than if it is not. Earmarking substitutes for a lack of trust between groups, and as a consequence it is found easier to arrive at tax-expenditure solutions. This does not, of course, imply any judgment upon the assumptions themselves. If any judgment were in fact to be made, it would be to regret that the absence of social and political harmony at the national and the international level makes resort to ear- marking necessary. This, however, is analogous to regretting that the selfishness of man as an individual makes it necessary to provide him with incentives to work more, etc., and with price disincentives which - iv - prevent his consuming everything up to the point at wqhich its marginal utility is zero. The definition of Pareto-optimality in all these instances assumes man and society as they are not as one might wish them to be.

The study proceeds to examine inefficiencies in the administrative allocation of existing public resources. These are differentiated as "administrative inefficiencies," as opposed to the political inefficiency in reaching a tax-expenditure decision at the legislative level, previously analyzed on the basis of the Lindahl model. It is demonstrated that a sub-optimal expenditure allocatiorn may occur not merely because of political inefficiency but also on account of vested interests among officials. "Administrative inefficiencies" result in tax proceeds being diverted to purposes in conflicting with the expressed interests of taxpayers.

Firstly it is argued that earmarking has a role to play where the efficiency with which funds are employed is undermined either by the incompetence of officials or by their corruption by political and other interests. In effect earmarking reduces the discreti-nory power of officials and thus, so the study argues, acts as a barrier to the diversion of funds away from the pattern which has been intended by the legislature.

Secondly, it is argued that a widespread problem in developing countries is the increase in the unit costs of capital projects which results from the fact that the flow of project funds is erratic and thus expensive equipment is not used to capacity. This is typically the case, for instance, with road expenditure. If by earmarking a revenue source to a project or to a sector, the flow of funds can be made more stable by, in particular, protecting it from periodic policies of budgetary restriction, then unit costs of construction can be reduced. Long term t planning will be encouraged as a result of the continuity in finance, andTcapable contractors will be encouraged to enter the industry.

A central issue of the study is the possible effectiveness of earmarking for dealing with the pervasive problem of the undesirably rapid growth of non-development expenditures. The study suggests that there are significant biases in government administration which encourage the growth of non-development expenditure (the so-called "Please" effect); the self-interest of government officials, the widespread desire for ostentatious luxury public consumption, the ease with which this expenditure can normally be increased as compared with the difficulties involved in undertaking investment expenditure in many sectors (industry, power, etc.). The recent quantitative work which has been undertaken has more fully confirmed the disturbing "Please" hypothesis and thus the need to find fiscal devices which recognize its nature and sig- nificance can no longer be neglected. Earmarking of funds for development purposes is one such device and should in certain situations be encouraged by, for instance, the W4orld Bank, in order to put whatever leverage they possess behind those groups in a country which support a greater domestic development effort, as opposed to the attainment of other ends of the society. The study emphasizes that earmarking has a "catalyctic" revenue raising effect analogous to the Peacock-Wiseman displacement effect. Peacock-Wiseman have shown that a considerable increase in public expenditure as a share of national product will only arise if a shock occurs, e.g., in the form of a war or an economic crisis. In the absence of a "catalyctic" or displacement effect, because of inertia and political and administrative inefficiencies, customary notions about taxation are likely to prevail over desirable increases in public expenditure. Earmarking, it is argued, can in certain circumstances provide the necessary "shock" to the system which is required to move it towards a more optimum level of government expenditure.

The study is buttressed by two empirical studies of earmarking and by references to experience from Brazil, Colombia, the Democratic Republic of Congo, Ecuador, Gabon, Iran, Morocco, and Peru. The first study is of earmarking of funds for highway development in some 40 countries, which in substance has already been issued as The Economics Department Working Paper No. 1. This study indicates that earmarking is associated with a higher relative expenditure allocation to the earmarked function than when there is no earmarking. The time series analysis adds strength to this conclusion. Initially one puzzling feature of the study was the fact that the average proportion of earmarked finance to total expenditure on highways was merely 37 percent, yet despite this a positive relationship appeared to exist between earmarking and a higher relative expenditure allocation to highways. This finding becomes less surprising if the recently acquired knowledge about the budgetary process in the U.S. is applied to the developing countries. This indicates that expenditure allocations take place on an tcre entala basis year to year. The previous yearts spending is taken as given when the current years's appropriations are decided. Therefore, when earmarking occurs, expenditures are likely to be pushed up to a higher level, which will not be retrieved. It should be readily apparent that if this theory is applied in particular to the LDC's, it is wrong to infer that earmarking is of mere nominal value if earmarked funds are supplemented by general fund finance. Earmarking is likely to have raised the absolute level Lspending-upon the I earmarked funiEon.

The other empirical study is a country study of earmarking in the case of the Philippines. Tax consciousness in the Philippines leaves much to be desired when it is judged against the need for public investment, in particular for infrastructure. The reasonsfor the lagging tax efforts are:

(i) A very individualistic society, where individuals are more important than party lines. (ii) Political interference in the public administration. (iii) Inefficiency in the public administration.

In 1966/67 earmarked tax revenue represented 11 percent of total tax revenue. There is reason to believe that in the absence of earmarking, most of this revenue would not have materialized. Earmarking has generally been directed to priority areas of economic development and is allocated for both current and capital purposes. Transportation has a high priority and it is significant that the only two investment fields where actual expenditure in FY 1967 reached or exceeded targets were highways and port- works, and these two functions benefit from a substantial earmarking. - vi -

To arize, from e re- cognized as a-ra.tiona1 instruent. Nonetheless, even while the benefits of earmarking in certain circumstances are clear, our support is not un- qualified. Earmarking may have a cost attached to it in the form of budget rigidity, which will in particular develop over time. Although in some - countries at certain times the absence of earmarking will limit revenue growth and thus no problem of the rigidity with which it is spent arises, the cost of rigidity more generally must not be neglected. Groups initially in favor of earmarking may realize that in the long run an excessive compartmentalizing of the budget may generate higher costs than benefits. In the study, we have pointed to cases such as Brazil where earmarking has been extensive and very rigid, but as a consequence it has been circumvented. For this reason, earmarking should in general be statutory rather than constitut gnal so that a simple legislative majority is abT-eto revise the legislation. Secondly, in the earmarking legisla- tion, it should be possible to stipulate that the arrangement be subject to periodic review. CHAPTER I

EVOLUTION OF EARMARKING

" I believe.. .that the inter-relation between the tax (cost) and expenditure (benefit) side of the budget is the essence of fiscal economics and that a theory of taxation distinct from that of expenditures has little economic meaning." 1/

Introduction

1. This study was initiated because there has been no known systematic attempt to evaluate earmarking of tax revenues as a fiscal technique, particular- ly in the context of the developing countries. Among economists, there is no consensus about the desirability of earmarking public revenues. Yet earmarking has been widely employed in countries throughout the developed and developing world. This contrast in itself would be an adequate justification for our interest. The study is normative in character. Answers to the questions why and when earmarking is used will be sought but in addition an attempt will be made to answer the question of when and where it is desirable that it should be used.

2. Earmarking has been the subject of criticism, particularly by the Anglo-Saxon school of public finance. This school formed opinions solely upon the tax side and failed to perceive the necessity for studying both the tax side and the expenditure side simultaneously. The determination procedure of taxes and the corresponding expenditures was overlooked. In fact, a study of earmarking leads us into the theory of taxation. Earmarking must be appraised in the context of the evaluation of alternative financing and expenditure policies by the political groups and the bureaucracy. Only then can any rational decision on tax and expenditure policy be made.

3. Too often, it appears that the mistaken assumption is made, in otherwise rigorous analysis, that countries and governments have a single preference function for public goods and services. When there is a single preference function for public goods and services, there is just "one will," and earmarking becomes non- sensical and irrational. However,in the real world multi-group preference functions prevail for public goods and services. Earmarking, therefore, must be viewed as a projection, in the field of budgeting, of an environment where competing group interests exist. The focus of the study is upon developing countries and it will be argued that conflicting group interests, a lack of social cohesion and political morality, is probably more prevalent in these countries than in developed countries.

1/ Richard A. l4usgrave. "Cornments on the Carter Commission Report." Canadian Journal of Economics, Feb.1968, p.161. -2-

For this reason, earmarking firstly assumes more importance in developing countries, as a mode of accommodation between different group interests. Accommodating group interests means that more revenue will be forthcoming - taxpayers willingness to pay will increase and the public sector will expand to a more "desirable" level. Secondly, earmarking may act as a constraint in budgeting at the administrative levels, and force a compliance with the budgetary allocations endorsed by the legislature.

Literature

4. In the U.S. early writers upon earmarking heavily criticized earmarking because of its shortcomings.2/ It appears that as earmarking spread, it became particularly distasteful to policy committees on local government. In 1947, the Council of State Governments wrote:2/

"It is recommended that earmarking of revenues be eliminated to every extent possible, and that all state revenues be deposited in a general fund from which they shall be appropriated for budgetary purposes. While some state legislatures may find it expedient to -earmark certain kinds of funds where there is a direct clear-cut, intimate relationship between the source of the money and the object of expenditure, the practice of earmarking is bad in itself because it frequently leads to extravagance and waste; and it is bad from the budgetary standpoint because the budget is incomplete when funds are levied, received, and spent outside the budget and without the control that budgeted expenditures receive. Even if some expenditures are earmarked, they should be included within the executive budget so that it can comprehend all revenues and all expenditures and present a complete picture of the state's finances. When a fund of the kind previously described is earmarked, the legislature should appropriate a maximum amount to be used with the proviso that any balance shall revert to the general fund".

5. However, it appeared that in the U.S., states continued to extensively use earmarling in spite of these recommendations. The literature on earmarking has remained surprisingly sparse. "A careful check of studied references as well as specialized taxation references revealed only a few quotations over the past de- cade".3/ Of the few writers on the subject,J.M.Buchanan has been particularly path- breaking in demonstrating the inappropriateness of the consumer demand analogy in the

1/ J.WIlner Sundelson, "Budgetary Methods in National and State Government," Special Report of the New York State TTx Commission, No. 14, Albany, J.B. Iyon Company, 1938, pp. 193-236. 2/ Revenue Dedication in State Government New Jersey State Chamber of Commerce, 1954, p. 22. Quoted in Earmarked State Taxes, Tax Foundation,N.York,1965, p.9. 3/ Earmarked State Taxes Op. cit., p. 22. analysis of group choice.1v "Despite the warnings of Knut Wicksell and a few others, economists and political scientists alike have carried on their work, as if the despots still reign supreme, as if a single decision-making entity makes political choices for the whole collectivity, as if their choices are not really influenced by citizens. "2/ Budgeting practices reflect and must be analyzed as alternative ways of resolvini conflict between divergent individual budgetary preferences. Through the voting mechanism, citizens decide the amount of public goods to be supplied. Buchanan's analysis supports earmarking as superior to general funds budgeting in certain respects. Yet, another rationale for earmarking was recently pointed to by Charles C. Goetz.3/ Goetz's analysis, analogous to Buchanan's refers to a group decision model and rejects individual decision models to understand legislative budget making. Goetz's contribution reveals the useful- ness of earmarking, when there are unstable majority coalitions at the legislative level and there is insufficient confidence between groups to enact tax-expenditure decisions.

6. A comprehensive analysis more fully based upon welfare economics comes from Leif Johansen.4/ Johansen analyzes the Lindahl theory, which is based upon the assumption that social goods are supplied in line with group preferences. There is a necessity of simultaneous consideration of expenditure decisions with the distribution of the corresponding tax burden to achieve Pareto-optimality. Johansen suggests that this argues in favor of a special assigning of tax revenue or earmarking. Musgrave is in favor of earmarking provided that a direct link to benefits can be established.5/ This is a support for earmarking in the context of user charges. Earmarking would be justified of taxes which represent or are close substitutes for direct charges for specific services rendered, e.g.,gasoline taxes are payment for highway use.

7. References to earmarking, in particular to its revenue raising effects are found more commonly in the literature on taxation in developing countries than in ordinary textbooks.6/ The need to improve the usually poor tax effort of developing countries is emphasized and particularly the learning effect of earmarking arising from establishing a link between the demand for public

1/ J.M.Buchanan, "The Economics of Earmarked Taxes," Journal of Political Economy October 1963, p.457.

2/ J.M.Buchanan, Public Finance in Democratic Process, The University of North Carolina Press, Chapel Hill, 1967, p.173.

3/ Charles C.Goetz, '"armarked Taxes and Majority Rule Budgetary Processes," The American Economic Review. March 1967, p.128.

4/ Leif Johansen, Public Economics, Worth Holland Publishing Co.,Amsterdam, Rand McNally & Co., Chicago 1965, p.139.

5/ Richard A.Musgrave, The Theory of Public Finance McGraw Hill.N.York 1959,p.178.

6/ See Earl Rolph and George Break,Public Finance, N.York, Ronald Press Co.,1961,p. 62and Jessee Burkhead, Government Budgeting, N.York,John Wiley & Sons, 1956 ,p.469. The argument refers to the financing of special functions in underdeveloped countries. By contrast,Walter Heller suggests that earmarking would reduce the willingness of taxpayers to approve expenditures Oil Spdcific public services. -4 -

services and the payment of taxes. Arthur Lewis states that teaching people to pay taxes for the services they want is the chief fiscal prol-lem of under-developed countries." 1/ Lewis recommends tying "the proceeds of a new tax to a new service, for instance, a tax on wages to a social security scheme or a tax on beer to an extension of the educational service." Prest agrees with the urgency "to survey the possibilities of special taxes for even though one cannot expect to raise sufficient revenue this way to meet total expenditure, no source of revenue can be neglected in the straightened budgetary conditions prevailing in many of these countries." 2/

8. It can be asserted that in countries starting on the road to develop- ment, an increased willingness to pay taxes is more important than fiscal flexibility. Thus, even while it is agreed that earmarking may hinder the flexibi- lity and comprehensiveness of the government's budget, the benefits of earmarking must still be recognized. This point is made by several writers. For instance Appleby argues that earmarked taxes on soft drinks, on electric energy, or on agricultural land for 1...-governmental activities important and vivid in the community would make such taxes more acceptable in whatever dimensions are in fact possible and equitable." 3/ There is an urgent need to foster an understand- ing of the benefit side of taxes, among the semi-illiterate masses in the develop- ing countries in order to increase the willingness to pay taxes. "By the time this major objective has been achieved, it will not be difficult to explain why flexibility requires that the practice be discontinued." 4/ However, it is not correct to compare the additional revenue with the need for fiscal flexibility. Since the additional revenue is raised precisely because of earmarking, it becomes irrelevant to discuss the rigidity/flexibility with which it is used as compared with a non-earmarking situation.

What is an earmarked tax?

9. It is necessary to distinguish between the various forms of earmarked taxes. In contrast to an ordinary tax, where the proceeds go into the pool of general revenue for allocation without consideration as to source, an earmarked tax is a tax where the revenue is assigned to a decreed, specified expenditure purpose. The earmarked revenue is separated from general revenue and classified

1/ W.Arthur Lewis, Development Planning, George Allen-Unwin, London, 1966, p.128.

2/ Alan Prest, "Internal Fiscal Policies and Education Programmes in Developing Countries," Financing of Education for Economic Growth, OECD,Paris, 1966, p.25.

3/ P.Appleby, Public Administration in India, Delhi, 1953, p.35.

4i W.Arthur Lewis, Op.cit., p.128 . -5 -

into special accounts within the budget or in special extra budgetary accounts. Also tax exemptions, foregone revenue, qualify as a form of earmarking; e.g., a tax credit against expenditure on fixed investment. Several types of ear- marking arrangements occur, but all of them have the common characteristic that there is a legal or statutory binding upon the use of the proceeds from the ear- marked taxes. Apart from the necessary condition of legal binding, earmarking as a concept is not well defined and it is necessary to distinguish between the different types.

Types of Earmarking

10. There are four possible types of earmarking:

(a) Specified tax base - particular end-use; (b) Specified tax base - broad end-use; (c) Unspecified tax base - particular end-use; and (d) Unspecified tax base - broad end-use.

A specified tax base with particular end-use is the most common form of earmarking. Illustrations are sales taxes on gasoline and liquor which are assigned to road and education expenditure respectively. There are also cases of individual taxes being earmarked for more particular purposes such as malaria eradication campaigns. Type (b) may be exemplified by oil revenue which is allocated to the development budget as a whole, rather than for a particular economic function. Types (c) and (d) are somewhat less common. From the pool of general fund revenue a given percentage is earmarked either to a specific purpose such as roads, or again to a development budget.

Insulation of revenue

11. A characteristic of earmarking is the insulation of revenue for the designated purpose. Frequently this insulation of revenue is further enhanced by the setting up of a special administration to allocate the earmarked fund, e.g., a road fund or a development fund. The same insulation of revenue within the public sector may occur with the creation of autonomous authorities which price their services. The setting up of quasi public corporations often serves the same purpose as earmarking. Although there are these similarities between earmarking and public authorities, there are also obvious differences. Most important is that in general earmarked revenue is collected from the tax paying public as a whole with no exclusion of tax subjects either on the cost side or on the benefit side, whereas in the case of authorities which price their services, only those among the public who pay, will be able to benefit from the corresponding services. Primarily because of this important distinction, public authorities of a goyern- ment enterprise character are not considered in the study.

12. Another important category of insulation of revenue,also outside the scope of this study, are various compulsory pension and social insurance schemes. These schemes are usually kept outside the state budget, but are akin to fiscal policies and earmarking, insofar as they require compulsory payment by or on behalf of the insured person for specific purposes. It will be apparent, however, that these different categories of government activities merge one into the other and that where the line of inclusion and exclusion is drawn is somewhat arbitrary. For instance revenues derived from road users which are earmarked for a road fund are on the margin of exclusion as public enterprises.

The tax base-earmarking versus general fund

13. Given an assumption that an equal amount of revenue will be supplied over a period, there are arguments which favor earmarking rather than general fund financing, in order to promote the evenness or continuity of fund supply. But the assumption itself must be investigated - namely whether there are likely to be differences in the flow of earmarked tax revenue compared with general fund tax revenue. Any difference in this regard, e.g., that earmarked tax revenue was subject to more instability at the source of collection might of course offset gains arising from the allocation of funds through earmarking. The long-term growth of earmarked revenue will, of course, depend upon the income elasticity of the earmarked taxes, whilst the shorter-run fluctuations in revenue will be contingent upon the sensitivity of the earmarked taxes to the cyclical behavior of the economy. No unambiguous answer can be given to the question whether ear- marked revenue will be more income elastic and be less sensitive to cyclical be- havior than non-earmarked revenue. Empirical evidence from the developing coun- tries, as well as from the U.S., indicate that earmarking is generally based uponi indirect rather than direct taxes. This would indicate that the growth of ear- marked revenue might be more stable than general fund revenue, since the latter includes revenue from income taxes. But where the earmarked indirect taxes are based on foreign trade, this situation would not necessarily hold true. A special case is revenue from oil in oil producing countries, which has been stable be- cause of the generally steady and increasing world demand for this commodity. Oil revenue earmarked for development is found in Iran and Iraq, and recently in Indonesia there has been an interest in introducing a similar scheme.

Developed countries

14. In earlier times earmarking was a common practice in European countries. Public services were mostly financed by special dues. The common belief was that the individual citizen should pay tax in relation to the utility he derived from the local or public services provided. In this traditional and individualistic society taxes were not looked upon as contributions to the maintenance of public services. The notion of sharing had not yet been widely adopted. The scope of government activity was also limited. But as the government over time assumed many of the functions and activities which formerly had been carried out by individuals, the taxes came to be regarded as general contributions to the main- tenance of a "common household." Taxpayers realized that the budget had an impor- tant function as a transfer instrument, and not only in providing the formerly essential services in the community. Gradually taxation and the corresponding public services, became to be considered in the light of welfare aspects and not only from the pure benefitrlpoint of view.

15. Earmarking diminished in developed countries. In 1787, England under- took a large scale budget reform and abolished its earmarking practice whilst * 7 - they still exist to a limited degree in other developed countries-./ Usually they are confined to areas such as gasoline taxes and highway expenditures, iwhere the benefit link is direct and obvious. The United States and Switzerland are two exceptions. These countries, both federally governed states, both have extensive earmarking. In the U.S., in 1963 earmarked tax revenue at the state level amount- ed to not less than 41 percent of total state tax collections.2/

Developing countries

16. Earmarking is much more common in the LDC's than in the developed coun- tries, In the developing world, earmarking practices are very frequent parti- cularly in Latin America but also in French-speaking Africa. Earmarking is found in Algeria, Morocco and Tunisia, as well as in most if not all of the French-speak- ing lWest African countries. There is much less earmarking in Ehglish-speaking countries. Since earmarking has been a more accepted practice on the European continent than in the U.K., it is not surprising to find that this difference is reflected in areas previously dominated by these powers. However, there is evi- dence that the practice is growing in Asia and Africa.3/

Earmarking and degree of social and economic development

17. A satisfactory explanation of earmarking, where this institution is an established fiscal device, can be made on grounds of the degree of economic and social stratification in a country.However,the fact that there is hardly any ear- marking in Egypt, and Nigeria, must be viewed against the negative attitude to this practice among the former British administrators. ' Equally important, there is a fundamental difference between the English or Northern European tax systems and its overseas extensions wqhich emphasize direct taxation, whilst the Mediterranean system embedded in the Latin World is biased in favor of indirect taxation. The earmarked taxes are generally based upon indirect taxes and very rarely upon income taxes. From this fact alone it could be expected that ear- marking would be found more extensively in the Latin World, than in the former British ruled territories. But the important question to be pursued is what fac- tors determine major reliance being placed upon the income tax rather than on in- direct taxes.

18. Richard Goode has listed the conditions necessary for a successful use of the personal income tax.4/ They amount to a fairly high degree of economic de- velopment, but in addition they emphasize honest maintenance of records, honest

1/ Instilling om Oremerlcing av Statsinntekter' Committee on Finance Policy, The Norwegian Ministry of Finance, Oslo 1966, p. 7. 2/ Earmarked State Taxes, Tax Foundation, New York, 1965. 3/ Albert Waterston, Development Planning Lessons of Experience, the Johns Hopkins Press, Baltimore, Maryland, 1965, p. 212. 4/ Richard Goode, "Reconstruction of Foreign Tax Systemsy Readings on Taxation in Developing Countries tn. bira and Uldman. The Johns Hopkins Press, Baltimore, 1964, p. 169. - 8 - administration and voluntary compliance on the part of the taxpayers. In fact, the English-speaking world with its reliance upon direct taxes shows a marked tendency to take its tax paying obligations much more seriously than the Latin World.l/ The listed requirements for a personal income tax imply a considerable degree of social and economic development. In other words, there is a need for the existence of respect for government, social stability and a high level of political morality.2/ The evidence of a higher reliance upon indirect taxes in the Latin world than in the English-speaking areas is no coincidence, but reflects clear differences in the political and socio-economic environment.

19. In this study it will be stressed that not only a large reliance upon indirect taxes, but resort to earmarking are effects of a common cause, namely the existence of a relatively heterogenous environment. Earmarking will be much less extensively adopted in a homogenous economic and social environment than in one with a higher degree of economic and social stratification. A study of politi- cal change in Latin America from 1945 to 1960 confirms that the educational level, the handling of governmental funds, the status of governmental administration and conditions of local government regularly were considered as leaving much to be desired.)/ There are compelling reasons to believe that the large degree of ear- marking in many Latin American countries has arisen out of an environment where there is a high degree of political, economic and social diversification, and wihere public administration is weak and where taxayers compliance is low.

20. A large degree of stratification means a large number of economic and social regional and non-regional groupings, all of which desire to promote their own interest by influencing and shaping government decisions in the field of pub- lic finance. Each group tries to obtain as much benefit as possible at a minimum cost. A two-fold approach is followed. Increased public spending is sought on those public functions which are favored by the group. Earmarking is a means to this end. Simultaneously, the groups attempt to obtain reductions of tax liabili- ties. 'When one group succeeds in improving its relative position, it is under- standable that other groups will follow suit, trying to regain previous relative benefit situations. It is necessary to v'nderstand that both assigning revenue for a given purpose and a reduction of tax liability may be analyzed as a benefit to a group interest.

1/ Milton C. Taylor, "The Relationship between income tax administration and income tax policy in Nigeria." Nigerian Journal of Economic and Social Studies, July 1967, Vol. 26, pp. 405-30. 2/ Taylor, Ibid.

3/ Russell H. Fisgibben and Kenneth F. Johnson, "Measurement of Latin American Political Change." The American Political Science Review, Sept. 1961, Vol. 15 No. 3, p. 515. CHAPTER II

BUDGET POLICY AND EARMARKING OF TAXES Targets of Budget Policy

21. In this chapter we will evaluate earmarking not as an isolated instrument of budget policy, but within the context of the determination of budget policy. Before undertaking this task let us consider budget policy itself. There are two main approaches here of which the simplest and most common is to state an objective for government policy and then proceed to ask what are the means at the disposal of the government, and how should these instruments be employed. This theory states that those with greater ability to pay - somehow defined and measured - should pay more. Customarily, public finance treaties have tended to separate the discussion of expenditures from that of taxation. In general the tax side has been dealt with at great length, whilst the pattern and level of expenditures have been taken as given.-/ Furthermore, the approach is analogous to regarding the public sector as an autonomous unit, comparable to the conception of a person as an economic unit. There is no attempt to build up any theory or model which would explain the behavior of the public sector under different external conditions. With regard to the general targets of budgetary policy they are familiar and can be expressed:

(a) Maintain common services - law, order and justice.

(b) Economic and social development.

(c) Stability in economic development.

(d) Income redistribution.

The minimum function of any budget would be to maintain common services. Common services are exemplified by fire, police protection and defense. Even in a primitive state this function would exist. With the transition of a nation from primitive to more advanced states, the objective of economic and social development will assume importance. Besides the afore- mentioned two objectives, as a rule there are side goals of budget policy, which express preference for stability or continuity in development. Finally, there is the need to achieve a more equitable income distribution by taxing

1/ P.A. Samuelson, "Pure Theory of Public Expenditure Taxation". Paper given at International Conference on Public Economics, Biarritz, 1966. Richard A. Musgrave, 1959. Cp. cit. p. 90. - 10 - the haves more than the have-nots, transferring funds fron the rich to the poor. A wide discussion of the means to be used to reach these targets and how they should be employed is outside the terms of reference of this study.

2Ž. However, from a consideration of the targets of budget policy, the question should arise whether there is a mechanism which determines the scope, composition and burden of public expenditure. To answer this question attempts have been made to explain budget policy and public behaviour from the point of view of the influences of the environment. In democracies, the common rule is that the government prepares the budget and presents this proposed budget to the national assembly. It is this body which has to make the final decision as to the state's income and expenditure. What is studied in this second main theory is the decision-making in a model national assembly. Emphasis is put upon the interests of pressure groups, the interaction or lack of interaction between social groups, the mechanism by which political leaders are selected and finally the knowledge (or lack of knowledge) of the decision-makers. The focal point of study is voting which is analyzed as the determinant of collective consumption. W4hen certain simplifying assumptions are made, a close analogy is found with the ordinary market demand curve.l/ It is within this basic context that a study of earmarking must begin.

The Benefit theory of taxation

23. It has already been noted that opposition to earmarking has stemmed from the inflexibility which it introduces into budgeting and consequently the reduced efficiency with which the resource allocation function of the budget is undertaken. It is argued that the binding of specific revenue or revenue sources to assigned expenditure functions by law or constitution will lead to inflexibility when economic priorities change. In this criticism a parallel is drawn to consumer demand theory, where the imposition of additional constraints from the point of view of an individual consumer is apt to produce an inferior budgetary choice. By and large the critics of earmarking have viewed budget policy as autonomous, with regard to those environmental factors we referred to above. In other words, the criticisms have arisen out of views which belong to a simple approach to budget policy, where the discussion of expenditures has become separated from that of taxation.

24. On the other hand those who have vieewed earmarking favorably, have emphasized the bridge-building function it performs between expenditure and taxes. The general argument runs that through earmarking, the public will grasp the link between public services and price or tax paid. The voters

1/ On this subject see F.H. Knight "Economic Theory and Nationalism" in The Ethics of Competition and Other Essays, New York, Harper and Bros. 1931. pp. 294-305; H.R. Bowen "The Interpretation of Voting in the Allocation of Economic Resources," Quarterly Journal of Economics; Vol. 58, November 1943, pp. 27-28. will be able to express their preference for public goods and this will draw them closer to decision-making in a democratic context. This will lead, so it is argued, to an increased willingness to pay taxes and thus additional revenue is likely to come forth which would not have materialized in the absence of earmarking. The composition and volume of public expendi- tures are determined through individual or group preferences by the willing- ness to pay. This "benefit" approach to taxation can be contrasted in public finance literature with the "ability to pay' school of thought. The short- coming of this latter approach is that it gives rise to no firm principle of tax determination and evades the problem of expenditure determination. 1/

25. The general problem that arises is how:to determine social preferences for it is this which is essential for identifying the social welfare function. What is of particular interest to us are the successful attempts which have been made to link the benefit theory with the welfare approach through focusing upon voting and the political process in the determination of expenditures. In this approach,to ascertain whether a position of optimum utility on the social welfare function has been reached, it becomes necessary to scrutinize majority voting and the legal framework for decisions upon taxes and expenditures. The criteria required to reach a position of optimum utility on the social welfare function are not fulfilled if under majority voting rules the minority becomes worse off. It is within this framework, that the analysis of earmarking is undertaken in this study. Our concern is going to be with groups and their interaction or lack of interaction.

Satisfying Collective Wants

26. In the traditional welfare theory under certain conditions the price mechanism will assure a utility level which satisfiei the conditions for Pareto-optimality. The price mechanism functions to maximize individual consumption of private goods in the private markets. In contrast, public goods are those goods which are subject to joint consumption. In general, strictly individual consumption of public goods is not possible. Nonetheless, many economist.s have endeavored to analyze whether the price or market mechanism could not also be made to operate in fiscal decision-making. Of the early statements of the new approach, those of the Italian school deserve special mentioning, e.g., De Viti de Marco, Pantaleoni, Puvian and Mazzola. 2/ De Viti de Marco, for instance, stressing the political nature of fiscal organization used two political models one of which is democratic or voluntaristic and the other of which is tyrannical or monopolistic. 3/

1/ Richard A. Musgrave, 1959 Op.cit.

2/ Richard A. Musgrave, 1959 Ibid; p. 70.

3/ J.M. Buchanan, 1967, Op.cit., p. 129 - 12 -

27. However, Lindahl, developing the theory of Wicksell in 1919, gave the first exposition in depth of the price mechanism in fiscal decision- making..I. In recent years, there has been a renewed strong interest in the Lindahl theory or the pure theory of public expenditures. Recent important contributions to public expenditure theory have been made by Musgrave, Samuelson and Johansen.V' Lindahl analyzed the determination of public expenditure and of the corresponding tax burden among the groups within the community. This makes it possible to regard the distribution ratio for this burden in a similar way to the behavior of prices in the adjustment between supply and demand in a private market. In his exposition, there are three aims:

(i) To establish the value of a "just" system of public ex- penditure and taxation, i.e., to develop a normative theory of the government's budget. (ii) To determine to what extent budgeting policy in a democracy does correspond to these ethical principles. (iii) In view of these findings, to recommend changes in voting procedures and tax legislation which would reduce the divergencies between the real world conditions and the ideal under democratic government. It is at this last stage that a simultaneous consideration of taxes and expenditures or earmarking becomes important. It will be seen that earmarking is an instrument which is efficient in expressing group prefer- ences and producing tax-expenditure decisions.

28. W3hat is a "just theory of taxation"? There are two significant preconditions to be fulfilled before a just system of public expenditure and taxation can be reached. The first requirement is that the socio- political function of taxation must correct existing inequalities in the income distribution. The second requirement is that the rest of the tax burden must be distributed according to the "purely fiscal functions of taxation" so that each individual equates expenditure (the benefit) on each public gppd, with the sacrifice represented by the tax price he must pay for the expenditure (and the sum of these tax prices is just sufficient to cover the cost of producing it). In other words, the rest of the tax burden must be distributed in accordance with the thus established just system of property. However, the determination of the just initial distribution of property is outside the competence of the fiscal theorist.

I/ Erik Lindahl, Die Gerechtigkeit der Besteucrung. Lund 1919. "Einige Strittige Fragen der Steuertheorie", in Hans Mayer (ed) Die Wirtschaft- stheorie der Gegenwart, Vienna, 1928. 2/ Richard A. Musgrave, "Provision for Social Goods". Paper given at the Conference on Public Economics. Biarritz, 1966. The Theory of Public Finance. New York, 1959, pp. 73-86. P.A. Samuelson, "The Pure Theory of Public Expenditure". Review of Economics and Statistics, 1955. "Aspects of Public Expenditure Theories", Review of Economics and Statistics, 1958. Leif Johansen, "Some Notes on the Lindahl Theory of Determination of Public Expenditures". International Economic Review. 1963. 1965. Op. cit. - 13 -

For this reason, the purely fiscal theory must proceed on the basis that a just initial income distribution exists or upon the weaker sssumnption that the income distribution is given.

The Lindahl Theory

29. At this stage only a brief summary of the conclusions which can be drawn from the Lindahl theory will be given. The model is more fully discussed in an Annex to this chapter. This model deals with two economically homogenous groups of satisfaction maximizing citizens. There is one public good - G. Political power is equally distributed between the two groups inso- far as they are equally able to safeguard "the economic rights to which they are entitled under the existing property order". 1/ The model deals with the "purely fiscal" aspects of the determination of ppublic expenditure and taxation; the existing income distribution is assumed to be given. In determining the expenditure-tax mix, there is free agreement between the two groups. In effect, the political situation is compared to a market situation of bilateral monopoly or of isolated barter. The magnitude (h) reflects the distribution of the fiscal burden to finance the goods and services provided in the public sector. If group A's tax burden for the public good amounts to (h), then by implication it becomes (1 - h) for group B. When (h) increases this implies that group A has to pay a higher price measured in terms of the decrease of its private consumption of goods and services, to ensure that the output of the public good is expanded. Conversely, B would bear a reduced burden.

30. Under certain simplifying assumptions, it can be shown that to obtain Pareto-optimality, each group's preferences must be accommodated so that it pays for the exact amount of public services it desires by a reduction of its private disposable income. Each taxpayer equates his marginal rates of substitution between goods supplied for the satisfaction of social and of private wants with their respective price ratios. (See Annex I). In other words, the (h) which is reached in the intergroup bartering must correspond to the ratio desired by both groups. At this stage, in a situation, where instead of one public good there are two public goods - G1 and G2 - it can be shown that there must be two distribution ratios (hl) and (h2), one for each public good;. If there is only one th), tne solution to the model is indeterminate, and no Pareto-optimal point will be reached. To achieve Pareto- fttfrmality, there is a necessity of a simultaneous consideration of both the pattern and level of the public expenditure, together with the distribution of the corresponding tax burden. This is a fundamental point in our exposition. We will see that the real world conditions are likely to

1/ Erik Lindahl, Op.cit. 1919, p. 172. - 14 - introduce a number of imperfections into the model, analogous to the situation, where there is only one distribution ratio (h), whilst there are two public goods. The question of policy interest is what are the means to go from the situation, where there is only one (h) and two public goods, to the situation where there is both an (hl) and (h2) for public expenditures Gl and G2, respectively? We find that in this context a specialization of the budget, an earmarking of taxes will assume great importance.

User charges

31. Where there is a direct link between tax and benefit, the deter- mination of distribution ratios of benefit/tax burden ratios for public expenditures is facilitated. Group preference will be more clearly expressed for public goods of group good character than for so-called national goods, such as defense. Group goods are often, although not always, public goods or services financed through user charges or special assessments. User charges may be earmarked or not. One of the most common types of earmarked user charges are taxes on highway users, earmarked for road construction. Often, farmers pay special levies for the use of public irrigation facilities. Other illus- trations are abundant. In the Central African Republic, for instance, there is a tax on forestry operations which is assigned to forestry research.

32. Musgrave is one of those supporting earmarking of user charges,. but he opposes benefit taxation to finance public goods with distinct consump- tion externalities such as education, especially at the primary and secondary level in developing countries. 1/ "Education expenditure, to be sure, may be of particular benefit to families with children as against older people or to large as against small -families, but it would surely be undesirable (on both equity and incentive grounds) to let tlhis be reflected in the financing of education in developing countries." 2/ He concludes, general fund financing would be preferable to earmarking to avoid an underprovision of education. Musgrave's analysis is correct in that there would be an underprovision of education if only direct users of primary and secondary education contributed to its financing. But it is wrong to dismiss earmarking or benefit taxation for all categories of education. In the real world, there are many examples of a combination of both general fund and earmarked finance for education, just as well as for other public goods which have externality features. In many Latin American and in French-speaking African countries, there is an example of a typical benefit tax assigned to education; a payroll tax on large enterprises is earmarked for technical and vocational training, which is an obvious benefit to those paying. In Pakistan, there is a similar tax for education; large companies have to pay a so-called apprentice

1/ Richard A. Musgrave, 1959, Op.cit., p. 178.

2/ Richard A. Musgrave, "Notes on Educational Investment in Developing Nations," Financing of Education for Economic Growth, Op.cit., p.39. - 15 - tax, which is a percentage of their capital costs. 1/

3.3. An earmarked tax is not necessarily identical to a benefit tax or a user charge. In Colombia, for example, a tax on liquor sales is earmarked to departments for the purpose of paying teacher salaries. Those who use liquor and those who benefit from good teaching instruction are generally not the same. Earmarked taxes do not need to reflect a link between the tax on a group and the corresponding benefit to this group. It can be shown that the link between tax preference and expenditure preference need not be direct. (See Annex to Chapter II). "There may be proponents of an export tax earmarked for port development, and of a sUiles tax on liquor earmarked to education expenditure. In the logrolling process, the result might turn out to be some earmarking of the export tax to education and a corresponding assigning of the sales tax to port development." Typically, however, it would appear that the propensity to employ earmarking of taxes is higher for public goods with few externalities, i.e., for what we call "group goods", whilst the general fund, or ability to pay taxation, is more likely to be used to finance public goods with distinct externality features.

34. In the Annex to this chapter the basic theory is outlined. We discuss in detail firstly the Lindahl theory and its assumptions, and secondly group behavior under voting with a majority rule budgetary model. In Chapter III we will compare real world conditions with the Lindahl model to determine what are the divergencies. To start with, we will compare an actual system of parliamentary democracy with the model and subsequently we will examine these matters in the context of the developing countries. (Chapter IV).

1/ Referred to in A. Aluko, "Public Finance and Education in Nigeria." Conference on Public Finance and Education, Institut International de Finances Publiques, Paris 1966, p. 293. ANNEX Page 1 ANNEX CHAPTER II

The Theory of Satisfying Collective WJants

The Lindahl Theory

1. In this exposition we will mainly follow Leif Johansen's exposition and proof of the Lindahl mechanism. This contribution, together with those of Samuelson, are outstanding in the field. 1/ Suppose we have two individuals, or groups A and B. The gross national income consists of the ccmponent privately allocated to A(X), the component privately allocated to B (Y), and the part wihich is available for joint consumption, (G). In other words:

(1) R = X + Y + G

The income of the two groups before taxation, when G must be zero is: R = RA + RB. When taxation is introduced, the distribution ratio h indicates the reduction in private disposable income, which corresponds to the supply of public goods and services when the total income R is given. The magnitude h reflects the distribution of the fiscal burden to finance the goods and services provided in the public sector; h shows share of joint expenditure G borne by group A, and (1-h) the burden for group B. The budget conditions become:

(2) X + hG = RA; Y = (l-h) G + RB

It is seen that by adding these two budget equations, we obtain the equation (1).

2. Let us analyze group A's preferences with regard to private and public use of resources, when the above budget conditions are given. The utility or welfare of group A is a function of its private use of goods and services and its joint use G. The utility functions are identical to those used in ordinary demand theory with the exception that G, because of its externality features, occurs as an argument in the utility functions of both persons or groups. In other words, we are concerned with a pure public good which enters into every- bodyts utility. The function can be expressed:

(3) UA = FA (RA, G), and similarly for group B.

UB = FB (RB, G).

lJ Leif Johansen, 1965, Op. cit., p. 125. For other expo3iticnz, of the Lzndahl theory, see Richard t.. ulsgrave, 1959, Op. cit., p. 74. ANNEX Page 2

At this stage, it is appropriate to introduce a social welfare function:

(4) W - W (UA UB), which is dependent on the utility levels of the two groups. VWe assume that the group regards the magnitude h as given. The following diagram illustrates A's preferences for given values of h.

Figure 1

RA . < ~~~~~~A'

3. The indifference curves are drawn according to the utility func- tions of group A. The straight lines correspond to the budget conditions. The budget lines become steeper the higher the value of h, which is evident since the slope of the line is (1-h), where -1 i- h It 0. The package pre- ferred of private and public goods and services for a given ratio h, is de- termined by the point where the budget line is tangential to a curve of indi- fference. Tie points P and Q satisfy these conditions. By linking up these points we obtain a curve, the left terminal point of which is found wshen group A is charged with the whole tax burden of financing G or when h = 1. Conversely, the right terminal point is defined as the point when h = O, and where group B bears the whole burden for the public goods and services. It is apparent that as h increases or the budget lines become steeper; i.e., the point of tangency of the indifference curve is moved from P to Q, A will desire decreasing mag- nitudes of G. In order to analyze the two groups demand for public expendi- tures at different distribution ratios h , it is necessary to study Figure 2. ANNEX Page 3

Figure 2 h

A

h2' , ,B

h, A'

B G G

4. In Figure 2 the curve AA? is identical to AA' in Figure 1. The latter figure shows that the desired magnitude of G decreases, as h increases or when the slope of the budget line becomes steeper. The larger the share of public expenditure imposed upon and benefiting group A, the smaller will be the group's desire for public expenditure. In other words, for A there is a declining marginal utility of public goods, when they are supplied in excess of the optimal distribution ratio S. The diagram is similar to a price quantity diagram where ALV represents the demand for public goods and services and h denotes price paid in terms of a decrease of group A absorption of private goods and services. Identically to curve AA'. we can draw a line BB' whibh is the demand of groupi B for public goods and services. The curve BB' will, however, be'drawlidifferently from AA', since it is determined by (1-h) and not by h.

5. Figure 2 allows us to study the mechanism for determining the cubic expenditure. The value h characterizes the equilibrium point, where the two groups desire the same magnitude of public expenditure. Thus h denotes the distribution ratio for G or equilibrium price in the "market" for public and private goods. In this market both groups consider the price as given and adjust quantitiesso astomaximize their utilities. Whenever h deviates from h, there will not be an agreement between the parties about the amount of public expenditures G. ANNEX Page 4

Haw to Reach the Equilibrium

6. If a high value of h exists, group A will try to reduce public expenditure, whereas group B wiU strive for more public expenditure. The reverse is true for a low value of h; group A desires an increased magnitude of G and group B a smaller amount.

7. How is agreement about a distribution ratio reached between the two parties? If in Figure 2 the distribution ratio is h. (hI / h), group A wants a larger amount of public expenditure, whereas B is opposed. In this case, it is likely that to reach agreement with B about the need to increase G, A would have to accept bearing a higher burden of the joint costs. It follows that there wiU be a movement towards the equilibrium h, but at a higher level of public expenditure. On the other hand, if the ratio is h2 (h 2 > h), it can be conjectured that B in pushing for larger public ex- penditure, to accommodate A would agree to a ratio h less than h 2 . To summarize, at values of h different from h, there are forces which wiUl move the distribution ratio towards the equilibrium h.

8. In our case, the market is not a competitive one. The two groups, A and B, are instead engaged in a kind of isolated barter. In order to reach the solution point P, through negotiating and bargaining, it is necessary to assume that each party has power and ability "to defend its own interest". It is well known that in ordinary welfare economics, under certain conditions when prices are given, the behavior of the parties involved will lead to Pareto-optimality. We will not enter into the proof of this Pareto-optimality. It can be shown that the Lindahl solution P satisfies the conditions for Pareto-optimality and that this is true without regard to the income distri- bution before taxation RA and RB. I/ Lindahl emphasized that this solution however would only be a good one if "the distribution of income before the parties concerned are subject to taxation for covering public expenditure, is acceptable or equitable." But it does not follow from this that this solution will generate maximum welfare, by giving maximal value of the welfare function given in (h). Originally, the P point solution was conceived of as a good one if: the distribution of income before the parties concerned are subject to taxation for covering public expenditures is acceptable or equitable.

Benefit allocation versus redistribution equity considerations

9. On this ground, Lindahl and others argued that the problem of taxation and public expenditures should be dealt with firstly as a redis- tribution problem and secondly, once the redistribution problem has been solved, the extent of public expenditure and the distribution of tax burden should be determined by the Lindahl mechanim. In particular, Musgrave has been influen- tial in this discussion with his separation of the budget into stabilization,

/ Leif Johansen, 1965, Op. cit., p. 135. ANNEX Page 5 distribution and allocation branches. 1

10. P. A. Samuelson has disassociated himself from this school in analyzing the Lindahl model. In a general fonmulation of the pure theory, he points to the impossibility of truly separating benefit-allocation and redistribution equity considerations since they intrinsically overlap. v/ However, he later concedes that it is possible to give the partial separation of benefit-allocation and equity redistribution elements some analytical meaning. The initial distribution o'f resourc'es is derived from the social wJelfare function. This -resource endowment is fixed simultaneously with the determtiation'of the public goods (th±ough the Lindahl mechanism) so as to' 6ffset any inequities iwhich might arise in this endowment. On these condi-- tions, Samuelson agrees to the separation of the distribution and allocation branch.

U1. In our exposition, we regard the point P as the optimal solution, since the initial distribution of resources has been derived fram the social welfare function. In the pure model, there may be an inconsistency arising from possible income effects from the determination of social goods. However this difficulty is solved if one assumes that the incame effects for each voting group wash out in each period. Alternatively, the problem may be solved on the assumption, not unrealistic, that these income effects are small and negligible in comparison with the initial resource endowment and the income redistribution policy.

Revelation of preferences

12. The point of departure in the discussion of the model has been the assumption that social goods shcold be supplied in line with individual pre- ferences. Whether or not one ascribes to notions of an organic theory of the state, it is podsible that preferenices are imposed within certain'* limits by a chosen elite, be 1G oecause its members are "beTter educated, possess greater innate wisdom, or belong to a particular party of sect! 2 In this case the welfare function would be written:

(5) w = W (UA, UB, G)

V RichardA. I-hsgrave,' 1959, Op.' oit.

2/ P. A. Samuelson, 1966, Op. cit., p. 8. ] Richard A. Musgrave, 1966, Op. cit. p. .17. ANNEX Page 6

Maximizing this formulation subject to the subsidiary conditions, (1) produces a solution which is not optimal.!/ Can this dilemma be reconciled? Che way of solving this problem is by pointing to that rational choice requires an acquain- tance with alternatives, for wmhich reason a temporary imposed choice may be justi- fied as an aid to the learning process. Thus, in the long run, this solution be- comes identical to our previous assertion that the satisfaction of individuals and groups may comprise elements of direct satisfaction from the enjoyment of pub- lic goods as well as altruistic elements. For instance, the provision of social goods the purpose of which is to reduce inequalities of income distribution would qualify as giving rise to "altruistic satisfaction".

13. In the evaluation of utilities, wfhich is of concern is the marginal utility.Z/ Johansen points to the important implication of the marginal utility approach, if there are public expenditures which can be referred to as "inferior goods". Public goods and services, the consumption of which is subject to decreas- ing utility with increasing income would be classified as inferior goods. It can be shown that in the case of an unequitable income distribution between the two groups, the group which is better off will pay a smaller share of joint expendi- ture. Reasons can be given both for and against the notion that public goods are inferior goods. Johansen himself considers that although there may be individual cases where components of public expenditure are "inferior"., to establish general propositions of this kind would be unrealistic. One would agree with this. There is certainly nothing which, a priori, suggests that the demand for such a main item of public expenditure as transportation would level off as income rises.

14. A major criticism of the theory has, however, arisen because it can be demonstrated that the voluntary exchange, the revelation of prqferences which the Lindahl model assumes, is going to suffer from imperfections.3/ In contrast to the case of private goods where the individual must reveal his preferences in order to purchase and enjoy the good, in the case of a public good with consumption exter- nalities, it is in the interest of the voter-consumer not to reveal true prefer- ences. However, firstly, it is not unrealistic to assume that in many instances the individuals are stratified into homogenous groups, and where each group has its representative spokesmen. As we have seen, the complexity of decisions on costs-benefits of public expenditures leaves little elbow room for an individual to decide. Those who will be in a position to know - or should know - are the

1/ Leif Johansen, 1965, Op. cit., p. 128. 2/ I4yrdal for one, argued that the relevant concept is total utility. G. Myrdal, The Political Element in the Development of Economic Theory, London, 1953, p. 187. Lindahl himself countered this criticism in an article in 1959: "Om skatteprinciper och skattepolitik" in Ekonomi Politik Samhalle, Stockholm, 1959, p. 151. Lindahl pointed to that total utility is something entirely undefinable. 3/ Samuelson, in particular, has made his criticism: 1966, Op. cit.. AINNEX Page 7

political leaders. Yet, there is a difficulty because game theoretic considera- tions are involved. For instance, let us look at a simple case, where there are only two groups, A and B, and A would like a higher level of the public good than B. If both vote, and they have equal weight attached to their votes, A would not get as much of the public good as he wants. Upon reflection, A will find that by voting for somewhat more than he in effect wants he easily can improve his posi- tion. It would be surprising if B did not try the same, by voting for somewhat less than he really needs. If A votes for twice the level that he really wants, and B votes for zero, A easily wins. There is an asymmetry, since A can vote for as large a scale as he chooses, but B cannot vote for less than zero. In the real world, however, this problem will cause us less concern. There will be a continu- ing game between A and B, where A's and B's preferences for public goods will not necessarily be in the same rank order for different public goods. Moreover, as the number of groups multiply, the difficulty of coordination of all the game theoretic considerations would tend to dilute the possibility of individual group gains. Finally, the most important argument appears to be that the political groups will realize that the political bargaining is not a one shot affair,but will continue over time for which reason a certain "code of conduct" will be necessary. It is, therefore, not unrealistic to assume that in the political negotiating, a fuller revelation of preferences will take place.

A More Realistic Model with Two Public Goods

15. At this stage, to make our model more realistic, let us look at the case where public expenditure G is subdivided into G1 and G2. The utility func- tions will now be written:

(6) UA = RA (X1, G1 , G2 )

UB RB (Y1, Glj G2)

There are now two instead of one components of public expenditure appearing in the utility function of each group. The corresponding budget equations are:

(7) RRAX+h X + h G1 + h 2 G2

B = y + (l-h1 )Gl + (l-h1 )G 2

On the assumption that group A accepts both ratios, h, and h2 as given and maxi- mizes its utility, it can again be shoaLm that the solution satisfies the necessary conditions for Pareto-optimality.l/

16. In this case, when we have two components of public expenditure, what would be the effect if we had only one distribution ratio h? The budget conditions will be rritten:

1/ Leif Johansen, 1965, Op. cit. p. 139... ANNEX Page 8

(8) X + h(Gl + G2) = RA

y + (1-h) (G, + G2) = RB

It is apparent that there are too many equations in relation to the number of variables. Since h was substituted for h, and h9, there will be one variable less than the number of equations. It follows, that it is not possible to deter- mine any distribution ratio h, upon which there is an agreement between the two groups on both the components G1 and G2 and the entire burden of financing G1 and G2 . 17. Johansen concludes that "the line of thought here illustrated may be interpreted as an argument in favor of dealing separately or simultaneously witlh fiscal arrangements, (i.e. methods of distributing the burdens) in connection with each one of the public expenditure items.!/ In the absence of a simultaneous deter- mination of taxes with expenditure, of a full accommodation of group interests, the Pareto-optimalsoluticn will not be reached. There may be implicit or explicit (ear Merki0j%signing of revenue. Of particular interest to us is that the model points to that explicit assigning or earmarking may be necessary to achieve Pareto-opti- mality.

Group Behavior Under Voting - A Majority Rule Budgetary Model

18. At this point it is necessary to recapitulate. The necessary conditions for Pareto-optimality have been established. The next question to pursue is how to select one of the Pareto-optimal points as the best. Whereas Samuelson's con- tributions had to do with welfare optima, he hardly paid any attention to the peculiarities of decision making about public goods. In order to attempt a bridge building between the Lindahl model and the real world, the peculiarities of voting and group behavior must be studied. An analysis of political institutions is necessary to determine the spectrum of possible solutions. For this reason, ma- jority voting must be considered. Through majority voting the coercive power of the state must be used to compel tax contributions. Although this institution suffers from certain flaws, under certain conditions it will produce a good solu- tion (See Annex I). However, in our analysis, there are reasons to remind our- selves of that "politics is the art of compromise among the conflicting interests of incommensurate groups."2/ A possible bridge between the ideals established in the framework of welfare economics and the pulls and the pushes recognized by the institutional political approaches is earmarking.

19. A recent contribution further explaining the "simultaneousness" condition with the objective of showing the rationale for earmarking was made by Charles Goetz.3/ In this paper, the notion we derived from the Lindahl theory is further developed that a simultaneous consideration of the tax and expenditure decision may warrant earmarking. In the absence of earmarking, there might be noconfidEnce, no vote trading and a less optimal solution may win. Goetz' starting point in developing his model is that general fund budgeting implies separate decisions

1/ Leif Johansen, 1965, Op. cit.' p. 140. 2/ Charles E. Lindblom, The Intelligence of Democracy, New York, 1965. 8 3/ Charles J. Goetz, Op. cit. p.-12 . - ANNEX Page 9

on expenditures and the ways the financing is obtained.

20. In a multiperson (-group), majority rule budgetary model, there is an expenditure choice between two public goods xl and x 2 , and a choice of financing between two tax systems T1 and T2. The public goods may be single as well as composite goods. Equally can there be a single tax or a tax mix. With regard to the assumptions, firstly the preferences for taxes and expenditures are ex- pressed by three single individuals or three homogenous groups of equal size. Secondly, each voter's preference index for tax and expenditure is measured in a cardinal way, although a simple ranking or an ordinal relationship is only necessary to achieve the basic effects of the model. Thirdly, it is assumed that each voter has a reasonable knowledge about other voterslordinal preferences be- tween alternative expenditure compositions. Fourthly, there are no income effects which would modify the individual evaluations of expenditures and taxes.

21. With these three decision matrices, the voters' preferences for alterna- tive tax increments and alternative expenditures are analyzed. The model sets out the behavior of the three "groups" on the assumption that the tax decision enters first in time and that in the next stage the expenditure allocation is determined.l/ Thus in the actual voting the preferences of the voters between T, and T2 are independent of the expected decision about expenditure composition, but subject to the limiting "common sense" condition that the value of the ex- pected expenditure allocation must exceed the tax costs. In the absence of these qualifying conditions there will be no belief in the necessity of increased taxa- tion. Let us now consider the model.

22. Table

Decision Matrices derived from Groups' Preferences of Incremental Evaluations of Expenditure and Tax Increases Preference I Preference II Preference III

To T_____To T, T2 To T1 T2 IXO O (-4) (-7) XO 0 (-5) (-6) XO 0 (-16) (-h) X1 (+6) +2 -1 X, (+4) -1 -2 X1 (+14) -2 +10

X2 (+12) +8 +5 X2 (+3) -2 -3 X2 (+12) -4 +18

To begin with, the X To position refers to the no-change situation. Logically, the Xn To and the X°O Tn solutions are excluded from the range of possible decisions. Tax increases without additional expenditures or conversely additional expenditure without tax revenue for financing are outside our interest.

23. From the matrices, it is seen that the majority prefers T over T2. 4 Next, the rnajority composed of Preferences II and III opts for X1 c er X2. The

1/ Even though the analysis of the model is based upon this order, it is easily shown that the conclusions of the model equally will hold if the expenditure allocation is decided upon first. ANNEX Page 10 combination of the two decisions would lead to decision X1Tl. But XlTl would result in a negative payoff for a majority. No feasible alternative is reached b mbinn Xl with T2 or alternatively X2 with Tl. Both X1T2 and x2 T1 would stcllo leadto a negative payoff for a majority. For this reason as long as X1 and T, are the expected expenditure and tax respectively, the majority will oppose a tax increase and choose To. A scrutiny of the matrices reveals a possible solution out of the stalemate. Preferences I and III both have positive payoffs for X2T2. Even while the situation is advantageous to them in comparison with the no tax solution, Preferences I and III may still not agree. The why arises because Preferences I's situation is delicate. Once taz decision T2 is taken, Preference I has no guarantee that Preference III abides to X2. It is equally possible that Preference III moves up to to maximize his benefits since the latter has a fair chance of inducing Preference II into an alliance. In fact, Preference II is likely to strive towards an alliance with Preference III, about X1T2, which is an improvement for Preference II.. Still, Preference I might agree to agree about X2 T2 , with some explicit or implicit vote - trading similar to the case discussed above.

24. On the other hand, there may not be enough confidence between the two partners for this to happen. And there will be no tax increment and no new expen- diture, even while there are definite majority gains to be realized by coali- tions.l/ Again, the simultaneousness condition has become paramount. The deter- mination of taxes and expenditures by the coalition can be made jointly and be en- forced by earmarking. This case clearly restates what we concluded in the dis- cussion of the Lindahl theory. An enforcement mechanism,an explicit assigning of revenue, may be absolutely necessary to assure Preference I that his positive pay- off will remain. In the absence of an enforcement mechanism, there is likely to be less will to negotiate and less vote trading.

25. In the Goetz model, the solution 2T 2 is not a Pareto optimal one, since Preference II is made to accept its least preferred payoff. There will be a majori- ty gain and a minority loss. Should then earmarking be prohibited? A Preference II voter might want to vote for a constitutional prohibition. But no majority for prohibition would be gained, in the actual case, since both I and III certainly expect a positive payoff from earmarking, compared to the zero payoff from general funds budgetary adjustments. Although constitutional prohibitions of earmarking do exist, there may be no rational basis for such a rule.2/ But if the matrices above merely are envisaged as the monetary yields from a varying payoff function, ear- marking may well be universally accepted and meet the Paretian welfare criterion. The payoffs of earmarking would be shifted over time. At a random distribution of I, II and III payoff matrices in the future budgeting legislation, where the identity of intense "winners" would be shifted around with relatively indifferent "losers", earmarking becomes the efficient way of optimizing group long-run gains.

26. An important feature of Goetz approach is that the link between the tax and expenditure preference need not be direct oqy a user charge such as the common

1/ The World Bank might even exhort a country, for new tax increases, but the status quo prevails in the absense of earmarking. 2/ Honduras has prohibited earmarking. ANNEX Page 11 assignment of gasoline taxes for highways. There may be proponents of an export tax earmarked for port development, and of a saies tax on liquor directed to edu- cation expenditure. In the log-rolling process, the result might turn out to be some earmarking of the export tax to education and a corresponding assigning of the sales tax to port development. CHAPTER III

COMPARISON OF AN ACTUAL SYSTEM OF PARLAMEINTARY DEMOCRACY WITH THE LINDAHL THEORY

35. The nature of political decision making becomes crucial when the Lindahl theory is compared with the actual conditions of a parliamentary democracy. Through majority voting, the coercive power of the state must be used to compel tax contributions and thus a number of divergencies arise when decision making under majority voting is compared with the Lindahl theory:

(a) Difficulties with individual evaluation of public goods and services. (b) Inadequate reflection of individual preferences in poli- tical programs. (c) Inadequate accommodation of minority and special interests. (d) Large number of groups. (e) Voting and legislative procedures which do not produce a simultaneous consideration of taxes with expenditures.

; (a) Individual evaluaticn

36. It is not easy for individuals to evaluate benefits from public services. "People are usually unable to appreciate the full implications of these very intricate matters, and must hence be content to guess the value of the advantages. In so doing, they are highly subject to the influence of public opinion." 1/ In matters remote from his daily concerns and preoccupations, the man in the street is easily swayed by arguments. How much should be spent on national defense? The average citizen is willing to hope that someone in the capital has figured it out about right, or else to accept the authority of his party's spokesmen. There is no alternative. Thus, there is reason to believe (or to hope) that the difference between the model, where we are concerned with representative group spokesmen, and the real world, may not, in fact, be too different. But prior to their oim commitment, these leaders must evaluate the likely preferences of other groups. Will the other groups reveal their true preference for the provision of public goods? The non-revelation of preferences by voters has been argued as a crucial flaw of the Lindahl theory. (See Annex to Chapter II) The voters would realize that public goods, once they are provided, are available to all. Preferences would not be revealed and there would be no voluntary exchange. 2/

1/ Erik Lindahl, 1928, Op. citb p. 218.

2/ P. A. Samuelson, 1955, Op.-cit. Charles E. McLure, 'Welfare Maximization", Canadian Journal of Economics, August 1968, p.. 637.. - 17 -

37. In ordinary market theory we know that consumers must reveal their preferences, since otherwise they will be excluded from the enjoyment of the good which they wish to purchase. In the case of public goods, such as defense, the situation is different. Practically no citizen can be excluded from the enjoyment of this good. It follows that the consumers will be reluctant to reveal their preferences. A consumer might reason that the total supply, and thus the benefits accruing to him, will not be significantly affected by his contribution. Therefore, there is an incentive for him to understate his preferences. The revelation of preferences for public goods depends upon whether these public goods are pure public goods such as defense where there are distinct consumption externalities to types such as education and road expenditure, where these externalities, at least for sub-categories will be less important.

38. Whilst there is no exclusion of citizens from the enjoyment of a public goods such as defense, this is not necessarily so in the case of public goods such as education and roads. Education expenditure like most other public expenditures, comprises many subclasses of expenditure per level of education, both functionally and regional. If pure public goods may be put at one end of the spectrum, at the other end will be found public services, the consumption of which is subject to almost fullI exclusion, i.e., there are few if any consumption externalities e.g., subsidized health facilities and low cost housing. A fuller revelation of value-preferences can be expected for "group" goods than for national goods. Therefore, although the Lindahl mechanism is generally valid, it is even more applicable to the former than the latter category. By and large, in this study we will be mostly concerned with public goods such as education and transportation, etc., where divergent and competing group interests are most likely to exist and where, it would appear, conflict situations between groups easily arise.

39. Since preference revelation is not secured automatically by the auction function of the market, a decision making mechanism, or voting pro- cedures, must be substituted for free voluntary exchange to determine prefer- ences. In a parliamentary democracy, a unanimous voting system is not likely to function and to be tolerated. The reasons are obvious - any voter would be able to veto the provision of social goods. The size of the public sector under unanimity voting would be rudimentary. In parliamentary de- mocracies, therefore, majority voting is the procedure used. Even under majority voting, complete preferences might not be revealed. In line with the above reasoning that the political leaders are those who make the decisions for the groups they represent, it seems fair to assume that the group leader will have had to learn the rules of the game in order that the bargaining process should operate effectively. Since he will be aware from experience that other groups are likely to seek gains by understating their preferences for public goods, he will undoubtedly adjust for this in his own opening strategy. But in the final analysis when deliberations among politicians are coming to a close and a vote is taken, it is not unrealistic to expect that all parties will arrive at a fuller revelation of preferences. Moreover, it must be recognized that individual preferences scales may include elements of altruistic nature as well as of narrowly self- interest. This latter possibility would, however, not substantially affect the Lindahl theory. - 18 -

(b) Reflections of Individual Preferences in Political Programs

40. In a parliamentary democracy, individual and group preferences can find effective expression only in so far as they are accurately reflected in the programmes of political representatives. In the real world, therefore, groups A and B must be regarded as the supporters of political parties A and B. It is unlikely, however, that in a democracy, political programmes can be stretched too far from the preferences of individuals since within a given time period there will be a regular general election, at which time "The politicians will have their error brought home to them". 1/

(c) Accommodation of Minority and Special Interests under Majority Voting

41. With regard to the problems of gaining full representation of individual and group interests, a fundamental divergence arises because there is no guarantee that "free agreement" between groups with "equal power" will be possible or will be permitted. Under majority voting, the majority may choose to neglect the minority interests. The majority might even consider it a luxury to enter into negotiations with the minority. In the model, the effect of this coercive element, due to the preponderance of power, is the same as if the weaker parties attach greater values to the public goods. 2/ The optimal distribution ratio will not be reached. Nonetheless, in the final resort, it must be kept in mind that there are rules of the game to be follawed if the notion of sharing, of a community shall prevail. Economic and political costs will arise if the majority party were in the long run to ignore minority preferences.

(d) Number of Groups

42. Whilst the Lindahl model only deals with two groups, in the real world there is usually a large number of groups. A large number of groups is likely to make it more difficult to reach a decision about taxes and expenditures. Cooperative solutions to preference revelation in the political process become harder to reach. There is a close analogy with market theory; under unilateral and bilateral oligopoly, as number increase, there is a problem, of achieving stable "qualified joint maximization" solutions through bargaining. 3/ We will return to the subject of unstable majority coalition below, particularly so in connection with the discussion of the characteristics of the developing countries.

1/ Erik Lindahl, 1928, Op. cit# p. 218.

2/ Erik Lindahl, 1919, Op. cit* p. 175.

3/ J. G. Head. "Lindahl's Theory of the Budget." Finanzarkiv - Band 23, Heft 3, 1964, p. 448. - 19 -

(e) Voting and Legislative Procedures

43. In most, if not all democratic systems, procedural rules for the conduct of voting on the volume and the financing of expenditures for a particular public good rarely allow a simultaneous consideration of the tax and the expenditure decision. "If Parliament were presented only with the totals of the tax bill and of public services, each p3rty would feel that it had failed to receive adequate return for the last unit of tax paid----There is only one way to avoid a contraction of public services harmful to all; each must undertake to pay a greater share than the other towards the cost of those services which each finds most useful. 1/

14s. The separation in time between tax legislation and the appropriations legislation under general fund financing is a factor which is likely to lead to a suboptimal solution in the Lindahl model. But as far as the voting procedure itself is concerned, can Pareto-optimality be guaranteed under majority voting? The answer is no. Yet in all those cases where the majority votes for a spending-tax solution, which makes a section of the community better off without causingany loss to the other members of the community, the conditions for Pareto-optimality are satisfied. It is easily understood that this may not always be the case; a majority ruling may incur a cost to the minority. The instrumentality of majority voting may, however, give rise to other complexities. In order to choose between alternative Pareto-optimal combina- tions of public expenditure and taxation, the alternatives should be ranked from "best" to "worse". To obtain an optimal solution, the extreme rather than the "medium" alternatives must first be voted upon and aetermined. How- ever, whenever the voters preference on utilities between consecutive al- ternatives in the ranking differs widely, the solution obtained is not satisfactory. When the utility function is discontinuous, majority voting does not assure a Pareto-optimal solution. (For a further discussion of this see Annex I.) There are various ways to overcome this difficulty, by types of weighted voting, which we will not enter into. 2/ In any case most, if not all, of these schemes appear to be too complicated for the real world situation.

Correction of Divergences

Costs and Benefit Evaluation of Public Expenditure

45. Because of the cumulative effect of all these divergences which arise when the Lindahl model is compared with a parliamentary democracy, the fiscal optimum will not be fully achieved in actual parliamentary democracies. Still the analogy between budget determination and price for-

1/ Erik Lindahl., Op. cit., pp. 173-174.

2/ Richard A.. Musgrave, 1959, Op. cit., pp. 130-132. Leif Johansen, 1965, Op. cit.., p. 148. - 20 - mation in the market is useful and important "the analogy of price formation in the public and the private economy is not unduly qualified by the above mentioned shift in the equiilibrium position as a result of an uneven distribution of power and other factors." 1/ Two primary questions arise. Firstly how can these divergences be corrected and secondly, what policies and techniques can be used for effecting the correction?

46. Comparing an actual parliamentary democracy with the Lindahl model and the possibilities of individual evaluation, we found that the assumption implicit in the model about representative group spokesmen is not unrealistic. The complex- ity and multi-purpose of many public expenditures has made an individual evalua- tion and weighing of costs and benefits of expenditure difficult. The political leader has had to fill the function of evaluating expert. Yet, even for the political leaders, the representative group spokesmen, the budget system and the political machinery generally does give far too little attention to the need for cost-benefit analysis of individual programs. In the U.S., for ins CO it is recognized that overall coordination is lacking. There is no formal machinery set up which could synchronize the decision making on taxes with that on expendi- tures. The appropriations committees and the authorization committees are relative- ly independent of each other.2/ With regard to expenditures, typically (though with some important exceptions - e.g.defense) there is as yet no systematic and explicit weighing of costs and benefits of authorized programs. There is a great emphasis on "bookkeeping" administrative control through scrutinizing details rather than evaluating major expenditure alternatives which is necessary for planning broad public policy. It follows that there should be much more reliance on program and performance budgeting which would facilitate an evaluation among voters and their representatives of costs and benefits of individual expendi- tures. In fact in recent years a program planning and budgeting system has been set up by the President to improve the evaluation of costs and benefits of expenditures and alternative programs. However there still appears to be room for considerable improvement of this technique within the U.S. budget system.

Separation between basic and appropriations legislation

47. The Lindahl model revealed the importance of simultaneity in the decision making on taxes and expenditures to achieve Pareto-optimality. But in practice, one of the obvious difficulties in obtaining a synchronization of the evaluation of taxes with expenditure decisions is the separation in time between the basic legislation and the appropriations legislation. Expenditure decisions are made annually as part of the routine of preparing the government's budget. In theory, the total burden of taxes must be consistent with these decisions. In fact, the distribution of the tax burden is reconsidered much more infrequently

1/ Erik Lindahl, 1928, Op.wots p.226 J.G.Head, Op.cit.p.429

2/ Arthur Smithies, The Budgetary Process in the United States., McGraw Hill,1955. - 21 - and with the main emphasis on aggregate considerations. Referring to this "stiff- ness" in the U.S.system, recommendations have been made that appropriations should be taken out of the present budgetary process so that in a feasible way appropriations can be linked very tightly to basic legislation.l/ This proposal conforms very closely with the conclusion emerging from the Lldahl theory.

4 . In the absence of a simultaneous consideration of the distribution of benefits from public expenditures and their link to the distribution of the tax burden, or implicit assigning of revenue, earmarking or explicit assigning of revenue will become increasingly important in accomodating group interests. Without a consensus and contract between groups as to the new expenditures and the distribution of the tax burden, new expenditures are less likely to be undertaken. The lack of simultaneous consideration of tax legislation with appropriations in the U.S. should be contrasted with the fact that earmarking is very common in the U.S. Thus, one may infer that there have been situations when earmarking was the only possible acceptable way to the public and the law makers to get new expenditure programs under way. The highway field is a classical illustration. I Unstable majority coalitions

49. Extending the analysis to other countries than the United States, the separation in time between tax legislation and expenditure appropriations is important in explaining the frequency of earmarking. But the occurrence of unstable majority coalitions must be added as a factor which increases the possible benefit from using earmarking. Earmarking has been emphasized as an efficient instrument not merely because it implies a simultaneous consideration of tax and expenditure, but also because it substitutes for a lack of confidence between interest groups through its binding character.2/ Where party discipline is an exception, where there is a lack of cooperation between groups, where the majority is composed of shifting socio-economic groups for different tax and expenditure decisions, in short where there are unstable majority coalitions, the lack of enforceability makes effective vote trading less likely. Earmarking can therefore be contrasted in this regard with general fund budgeting, which implies separate decisions on expenditures and financing. Earmarking provides an enforceable "tie-in" between the tax concessions and expenditure concessions which may be necessary to construct a tax-and-expenditure package with net benefits for a majority. However the link between the tax preference and the expenditure preference need not be direct. (See Annexto Chapter II). The dis- tin#qon betweeni stab1e, and unstable majority coalitions is fundamental in dis- cussing earmarking in the developing countries.

1/ Charles E. Lindblom, "Decision making in Taxation and Expenditures," in Public Finances, Needs, Sources and Utilization, a Conference, Princeton University Press, 1961, p.32d.

2/ Charles J. Goetz, Op.cit. p.128. - 22 -

Minority_Groups

50. To arrive at an understanding of how to safeguard minority or special interests and thus facilitate the reaching of Pareto-optimal situations, let us consider the following case. Assume that there are three groups of which C is the rich group. Group C does not belong to a particular region. Since the tax rates are assumed to be proportional more revenue is collected from C than from A and B. The majority vote prevails, for which reason it is not possible for Group C to unilaterally introduce a regressive system of taxation in order to reduce its absolute tax burden. Groups A and B will have an advantage in that they can command a majority for spending all the funds on their favored projects, which may diverge from those in the interest of Group C. How will the Group C's "excess" revenue be spent? Let us assume that Group C accepts - (is coerced) - that this revenue will be spent on education. Now, however, one may safely assume that the minority's view cannot be entirely disregard. Sooner or later a situation may arise where either of groups A and B needs the support of C. Obviously, the coalition of the poor could for some time ruthlessly exploit the rich in favor of projects from which they are the major beneficiaries. But this type of coalition would tend to be very unstable. The minority would always be in a position to break up the coalition by offering benefits. Therefore, we postulate that heed is taken to group C's desire that the money will be spent, not on any kind of education, but, e.g.,on university education. It is not surprising that in the face of a majority, the minority will desire to receive something more concrete than assurances, that in effect the money will be allocated to the agreed purpose. An agreement between a minority and a majority will always be somewhat unstable. No doubt, from the point of view of C, an earmarking arrangement would be both less unstable and more credible and therefore a more desirable form of contract.

5a. This case can be examined in an alternative way by introducing the assumption that the three groups represent three different regions. Assume that in region C there weuld be increasing interest in improving the road system by building a modern highway. To finance the contribution, the tax rates must be increased in region C.It follows- that region C would be subject to higher tax rates than the other two regions. Ordinarily, there would be opposition to an interregional differentiation of tax rates.l/ Generally the only acceptable justification of differentiating national tax rates is in instances when the "excess" revenue remains in the region. How can this be achieved? Since it was assumed that the tax is payable to the central government, the solution may again be earmarking. In the absence of earmarking, or returning the revenue to the source of origin, no highway construction would be likely and there would be resistance to increased tax rates within the region C. 2/

1/ Exceptions occur, e.g.,tax holidays for distressed areas.

2/ For a further discussion of "local interests" see Ieif Johansen 1965, Op.cit. p.151. - 23 -

52.. However, a geographical differentiation of taxation is cumbersome and uncommon in the case of taxes payable to the central government. The more obvious solution is to decentralize governmental policy making. In our case, this would mean that there would be at least a partial delegation of tax collection and spending decisions to region C. Hence, when group interests are delineated by geographical boundaries, earmarking as a way of accommodating differences in voter preferences may be an alternative to the decentralization of governmental policy making. Earmarking and decentralization may be treated as substitutes, but they must not be looked upon as mutually exclusive. From this point of view, it is interesting that in federally administrated countries like the U.S.A., Bra- zil and Switzerland, earmarking is frequent. Both the decentralization of govern- mental policy making and earmarking point to the fact that special interests have been accommodated including geographical interests.

Time Dimension

53. Fram welfare considerations, earmarking can be recognized as a rational instrument. It ensures a simultaneous consideration of taxes and expenditures, the importance of which was proven by the Lindahl model. Secondly, it provides the possibility of a legal contract which becomes increasingly important when there are unstable majority coalitions. For majority coalitions, earmarking be- comes a strategic tool. However, the Lindahl model is a static model and does not take into account the time dimension. In a dynamic model, whilst earmarking would be advisable for one year, over time the resource allocation pattern neces- sarily would have to change. As conditions change and new needs develop, groups would tend to become aware that expenditure allocations required modification. The same phenomenom would also occur because the incidence of the earmarked taxes would change over time. The "contracts" or the earmarking arrangements ought, theretofore, to be revised. Moreover, the overall short-run review and flexibility of the budget necessary for an effective anti-inflationary or demand-stimulating economic policy might be partly jeopardized, as the number of specific earmarking arrangements multiply.

5. % Thus from the point of view of overall efficiency, in which budget review is a necessary component, earmarking to satisfy the maximization of collec- tive wants must be viewed in a time dimension. Groups will realize that in the long run an excessive compartmentalizing of the budget may generate higher costs than benefits. For this reason, we would expect a certain reduction of earmark- ing to strike a harmony between the two objectives of maximum satisfaction of col- lective wants and flexibility in budget management. CHAPTER IV

THE L11ATIL THEORY APPLIED

551 The Lindahl theory is a political theory about groups and their behavior which shows us the mechanism for the optimum satisfaction of col- lective wants. The conditions to be satisfied to reach a Pareto-optimal solution are:

(i) A correct income distribution before taxation.

(ii) An equitable voting system in accordance with the existing income distribution.

(iii) A continuous utility function for the evaluation of public expenditures.

(iv) A simultaneous consideration of tax and expenditure decisions.

56. In the next stage of the analysis, the Lindahl theory was compared with a model parliamentary democracy. This comparison revealed that the op- timalization takes place under certain constraints, and that the divergencies with the model which thus arise are the consequence of the following factors:

(a) Difficulties with individual evaluation of public goods and services.

(b) Inadequate reflection of individual preferences in political programs.

(c) Inadequate accommodation of minority and special interests.

(d) Large number of groups.

(e) Voting and legislative procedures, which do not produce a simultaneous consideration of taxes with expenditures.

A maximum satisfaction of group wants will not arise because of income inequalities, imperfect representation of group interests, the free riders or non-exclusiveness of public expenditures, imperfections in voting procedures and a lack of simultaneous consideration of taxes with expenditures. In addition, there may be a lack of social cohesiveness, which will make a communication and the reading of agreements between groups even more difficult. We referred to this factor - exemplified in lack of respect for government, lack of social stability and of political morality - in discussing the require- ments for direct versus indirect tax systems. In the model parliamentary democracy, within the framework of these constraints, there would be pushes and pulls towards the optimum solution in the Lindahl model. Although all conditions rarely will be satisfied, the theory still allows us to understand the process or "motor" in the development of taxation and public expenditures. What is important is the environment and the interaction, or lack of inter- action, of pressure groups in their attempts to maximize their benefits of public expenditures.

58.. We refer back to the Lindahl model to illustrate the situation. (See Annex to Chapter II). Figure 1 shows the simple two groups - one public good model. The distribution ratio h denotes group A's tax burden and (1-h) group B's share of the public expenditure. It is only at PO that the utility of the last unit of public good produced is simultaneously equal to the tax price for both groups. But in the figure, the point P0 or the optimal level of public expenditure G at the distribution ratio h is not reached.

Figure 1

h-1

h - P2 "

hl~~~~~~~ 'I,/ At

iG 1 G Total Public Expenditure

59 . How can the equilibrium be reached? Suppose that the initial distribution ratio is h, (h 1 < hi). At this cost share, group A would like to see public expenditure pushed to the level represented by point S. But this is not feasible, since B would not be willing, at this price, to contribute the balance of total cost. Nonetheless, at the given cost ratio h,, both groups would prefer the level of public expenditure represented by l to any smaller outlay. There is a temporary equilibrium at P1 .

6o. The equilibrium is not stable at P1 because it is apparent that A's demand for public goods is far from satisfied. But there is an obstacle, in that B will only concede to a higher level of public expenditure, if its cost share is reduced. Group A must enter into a bartering with B. However, - 26 -

group A will have to assume a tax burden, which is higher than hl, to attain the desired higher level of public expenditure. It follows that point P1, will be shifted towards point P along the group B curve. It is at this stage that the negotiating or the bar2ering between groups becomes important, but agreement becomes more and more difficult as the number of groups increases. Irrespective of the number of groups, with an individualistic society, where cooperative behavior is lacking, the likelihood of unstable majority coalitions is high. Because of the institutional setting, reaching agreements between groups is going to be difficult and public expenditure will remain at the suboptimal level.

61. Once the divergencies between the model and the real world are known, it becomes possible to analyze the instruments which can be used to correct these deviations. The theory proved that there must be a distribution ratio for each public expenditure to ensure Pareto-optimality. This is equivalent to a situation in which each group's subjective preference for type and volume of public expenditure must be accommodated. This can only be done if each group compares the additional tax burden with the benefit of an additional unit of the particular good. This implies that there must be a simultaneous considera- tion of taxes with expenditure. In this "price fixing" there will have to be a bartering, a bargaining between groups. Just as market agreements between firms are in the form of implicit or explicit collusion, so in the "price fixing" for public goods implicit or explicit assigning of revenue is made. a&th full confidence between groups, a gentleman's agreement would be sufficient. With little confidence, there will be a recourse to contracts or legal "price fixing" about public goods. An explicit contract or a formal assigning of tax revenue becomes necessary to reach an agreement about a tax-expenditure decision. Earmarking assures groups about the end-use, the benefit of their tax payments. Our analysis showed that besides earmarking, two other instruments can be used to accommodate group interests, namely a decentralization of governmental policy making, and program and performance budgeting. Developing Countries

6?. In what way do the general conditions of developing countries differ from those of a "model" parliamentary democracy? The flaws (a) to (e) which arose when the Lindahl model was compared with parliamentary democracy will persist. In fact, the model will operate under even more constraints in an environment of a typical developing country. The additional flaws can be grouped under three headings.

(i) Unstable majority coalitions.

(ii) Political interference into the administration.

(iii) Administrative inefficiency.

These additional constraints, will all produce a situation in which earmarking becomes more important than in developed countries, in providing additional social goods and services. - 27 -

Unstable lajority Coalitions

63. Usually at a low stage of development the society is heterogeneous and fractionalistic. Because of the individualistic society there will tend to be a large number of social, regional and non-regional groupings all of which are possible pressure groups. This will be reflected in political life. Party discipline is likely to be weak and political alignments will be made on the basis of personality rather than on principle. This is the situation in the Philippines and it appears to be the same for many other countries (see case study on the Philippines).

64. Of course, even amongst developed countries the situation in this regard varies markedly. For instance, it is illustrative to compare the situa,on in the U.S., with the strict party discipline which prevails in the U.K.Y In the light of our analysis, it is not surprising to find that both earmarking and decentralization of administration are more widespread in the U.S. than in the U.K.. system of goverrment. The claim for the superiority of disciplined parties is generally made on the grounds of consistency and coherence. But in fact, excessive party discipline might lead to deficiencies in considering all possible oppctinities for agreement and acceptable aggre- gation on the provision of public goods and services between group interests. There is a minimum need for party discipline in the absence of which, there is likely to be very little, if any, tax legislation with the possible exception of tax exemptions. In this regard, the Philippines case again is instructive. Whilst in recent years new tax legislation has been very rare, there has been a striking abundance of tax exemptions. 65e In the political log rolling and bargaining procedure, the more individual and fractionalistic is society and the larger the number of groups, the more unstable will be the possible majority coalitions. Moreover, the lack of social cohesion generates a mistrust and lack of interaction between groups, of dimensions not likely to occur in developed nations. Decisions about taxes and expenditures are not likely to come off because of lack of cooperation between political groups and the complexity of the negotiations (See Annex to Chapter II, Group Behavior under Voting). The situation will, if anything, favor retaining existing expenditure and tax levels although new expenditures would b net benefits to a majority. This leads us to reaffim the importance of the simultanLeity condition and its manifestation in earmarking in developing countries. In other words, earmarking substitutes for a lack of confidence b3tween political groups and coalitions and brings forth revenue, which in the absence of earmarking would not have come forth.

66. Especially in South America, there is evidence which confirms the individualistic character of society. "Outside the traditional Indian world, cooperative ventures and collective decision making seem not to fit easily in

1/ Charles E. Lindblom, The Intelligence of Democrac, Decision Making through Mutual Adjustment, New York, London, 1965, p. 312. - 28 -

the various sub-cultures that make up Latin America".!/ Ecuador is a good illustration. In this ,country, the Central Government repeatedly has had difficulties in collecting taxes. In particular it has been difficult to collect revenue from the provinces which have displayed mistrust towards the Central Government. The unwillingness to pay taxes should be seen and explained not least against a poor performance in Central Government budgeting and tax administration. With strong regional interests in Ecuador, earmarking was the contract that assured the different regional groups that they them- selves would receive the benefits of increased taxation. It also appears that part of the reason for instituting earmarked taxes was to ensure that a certain proportion of tax revenue was directed into development. The slow evolution towards an environment, less fractionalistic and with more social cohesion, is well illustrated by the fact that the income tax as an institution only started in 1964.

1/ Public Administration - A Key to DeveloPment Baker Ed., (U.S. Department of Agriculture), Washington, D.C., 1964, p.44. CHAPTER V

TWO SPECIAL CASES Earmarking and Local Government

67. In the comparison of the Lindahl model with an actual system of Parliamentary democracy, it emerged that both a specialization of the budget or earmarking, and a decentralization of administration, are means to accommo- date Vinority interests. The discussion pointed to the importance of accommo- dating even particular interests in order to reach a maximum satisfaction of collective wants and that this accommodation of special interests is conducive to producing additional revenue, which otherwise would not be forthcoming. For this reason a comparison can be made between the payment of taxes which are reserved for community development and earmarking on the one hand and taxes collected for the central government budget and general fund financing on the other.

68. The taxpayer has much more certainty as to the final end-use of taxes paid, when they go to his own community, than when they are destined to and distributed by the country's central administration. "The connection between payment of local services is so direct and obvious, so much more convincing to the taxpayer and so much more stimulating to his interest than the remoter connection which is so often so difficult to see in a national budget". In effect, since earmarking creates the link between revenue raised and its employment, it is logical to argue that earmarking will be the more important the more centralized is the administration. Let us assume that each village is an autonomous entity. For these entities there would be little need for earmarking, since the villager/taxpayer would have little difficulty in identifying the end-use of the local collections. If misuse of funds should arise, the shield of anonymity, common in larger administrations, will not exist. The small size of activities and administration does introduce a strong element of control. This element of control is, of course, at its maximum when taxes are paid through contributions in labor, common in various community development programs such as local road building. The directness of the link will naturally depend on the size of the local body; there is probably an optimum size for each community beyond which the link between tax and end-use becomes faded, without an earmarking arrangement. A point is reached, even at the village level, where earmarking is the only way to increase revenues to finance needed expenditures. Villagers may agree to vote for an increased tax burden, but only if the proceeds are allocated to a specific purpose, such as education, health or local development.

69. To be more realistic, let us drop the assumption that each village or local administrative unit is an autonomous unit. Collection of taxes

1/ U.K. Hicks, Development from Below, Oxford 1961, p. 5. - 30 - start for the tribe as a whole and later for the central government of the country. The link which earmarking provides then becomes more important. The taxpayer willYpay his shiare less grudgingly, if he receives assurances of the nature of the corresponding expenditures. If he does not find visible results of central government spending in his own locality, he is likely to develop negative attitudes to tax collections for the central govern- ment, than if all the taxes he pays, or at least a part of them, are reserved for local development. Some form of local fiscal autonomy or earmarking becomes important, because it will pave the way for the evolu- tion of positive attitudes towards central taxation. At this point, it is not irrelevant to refer to the abundant historical evidence of negative attitudes to central government tax collections leading to rebellion and even to the break up of empires. In this light, it is not surprising that tax sharing is common, particularly in federally administered countries. The sharing takes place through the earmarking of centrally collected revenue to local administrative units in the form of fixed percentages of individual taxes, or of the total revenue collections.

Illustrations

70. In Africa, there have been numerous examples of earmarked taxes at the local level. These taxes (commonly called cesses) which for instance exist in Tanzania, are reserved for local development. "However bad they were as taxes, it cannot be denied that cesses did enable tax potential to be tapped, that would otherwise have been missed and thus provided funds to give new ideas of local government a start, they would otherwise not have had'".i/ In Nigeria, there is further evidence of the significance of local taxes. It is reported that, "the main reason for relying on local direct taxes rather than on the federal income tax is the fact that in the Nigerian situation - and that of many other underdeveloped countries as well - the willingness to pay taxes directly depends on the immediacy of the benefits of the government services which these taxes "buy". The rural areas of Nigeria abound with examples of virtually voluntary increases in taxes - where the taxpayer directly benefits from new or improved cvmunal facilities such as schools, hospitals, community centers and roads".-

71. Indonesia is another illustration. Already, at the beginning of this century, local councils existed which levied taxes for the support of

1/ U.K. Hicks, Op. cit. p. 229

John A. Adler: "Government Receipts and Expenditures in an underdeveloped Economyt". Readings on Taxation in Developing Countries. Ed. Bird and Oldman. The, Johns Hoplins Press, Baltimore, 1964, p. 492. - 31 - local projects, su4 as for education, water supplies, slaughter houses, public baths, etc.Y There is evidence that the local fiscal autonomy led to a high rate of locally financed investment. It appears that in Java since 19h9, the domination of local fiscal processes by the Central Govern- ment has impeded the local urge for development. The Indonesian experience suggests "that resources out of which local investmant projects may be financed lie near the local administrative level and can be effectively mobilized there".2/ Foreign Aid

72. So far in our discussion of the satisfaction of collective wants, foreign aid, or "external revenue raising" has not been considered. Foreign aid is either supplied through project or through program aid and there is a familiar and continuing debate over the relative merits of these two forms of aid which it is not part of this study to pursue. Our concern will be with the similarity between, on the one hand, project aid and earmarkig)g, and on the other hand between program aid and general fund financing.J

73. In the eyes of donor countries a distinct merit of project aid is that they feel assured of the final end-use of the aid given._

"... we have implicitly assumed that the aid-giving country and the receiving country are in broad agreement about the priori- ties and top needs of the aid-receiving country. If this assumption is not true, then of course the case for specific project aid is greatly strengthened!'.i/

Just as earmarking at the national level is a reflection of conflicting group interest in the use of public funds, so at the international level the tying of the assistance to projects and sectors is a reflection of a similar lack of confidence between nations, even when acting through an international agency.

1/ Douglas S. Paauw. "Local Finance in Indonesia",. Readings on Taxation in Developing Countries, Op. cit., p. 561. 2/ Douglas S. Paauw. OP. cit. p. 361 3/ In this discussion, earmarking refers to specific earmarking and not earmarking for a development plan. 4/ Whether or not they are justified in "feeling" assured of this is another question and one that is the subject of dispute amongst economists (see Hans Singer, "External Aid: For Plans or Projects", Economic Journal. September 1965, p. 539.) 5/ Ibid, p. 541. - 32 -

The inefficiencies which can arise from such earmarking are well recognized. It is equally recognized, however, that the flow of foreign assistance is likely to be considerably below its existing level, but for such earmarking arrangements. In fact, the analogy between project aid and earmarking is strengthened by the fact that aid givers usually require assurances that local matching funds for an assisted project will be made available in the volume and at the times which are agreed. The World Bank itself frequently seeks undertakings from governments regarding the local contribution to a project. In other cases a more precise earmarking of taxes for counterpart funds has been endorsed, encouraged and even insisted upon by the World Bank. Cases in point are Colombia, Costa Rica and Ecuador, where earmarked funds have been set up in conjunction with highway investment programs. In Gabon, earmarking has been particularly important in ensuring that counter- part funds are available to match external aid.

74. The earmarking of public funds for specific purposes at the re- quest or insistence of aid givers, can take forms other than the simple earmarking of certain revenues for these purposes. For instance tax exemp- tion for agencies undertaking a foreign-assisted project represents a form of earmarking of what would otherwise have been budget revenues. The World Bank, in some cases has, for exaiple, requested or agreed to customs duty exemption on imports finanq>d by its loans and for credits. The motives for this exemption have varied- but in some cases have been because of a fear that in a tight budgetary situation, the local contribution to the financing of a project will not be forthcoming or will be delayed. Import duty exemp- tion is treated as an alternative to the local contribution out of budgetary appropriations.

75. A second alternative form of earmarking arises in the case of the local contribution to public utility investment - electricity, railways, water - and also investment by the autonomous agencies (e.g. agricultural credit). The Bank has typically insisted that rate-covenants should allow for a margin for reserve creation for financing future investment outlays. In other words, apart from determining whatever should be an economic price for a service, in effect a tax on the service has been thought to be desirable which would be earmarked to the financing of further investment in the sector or by the agency. Part of the argument for this policy has been in terms of ensuring that the agency is more autonomous than it otherwise would be, but an important motive has also been to assure the agency a rnore adequate and regular flow of investment finance by insulating it from the uncertainties of budgetary policy. In principle, however, those who argue the preeminent importance of budget flexibility should, and have, argued that the margin on public utility prices for reserve creation (other, of course, than bad debt and other contingency reserves) should be considered as an excise duty and treated accordingly. In tlLis case the revenue would flow into the budget then to be appropriated, inter-alia, for public utility investment.

1/ See IBRD Working Party report on "The Treatment of Customs Duties on Goods procured for Bank-financed Projects". February 20, 1968. CHAPTER VI

BUDGETING UNDER INEFFICIENCY

76. So far "political inefficiency" in reaching a decision about tax-ex- penditures at the legislative level has been considered. Our analysis indicated the importance of earmarking as a device through which revenue can be increased when there is a lack of cooperation and confidence between political groups. This political environment is an "inefficiency" in the sense that it is one of the constraints which prevents fiscal optimality from being- reached and whichM.mits the growth of public expenditure. But there are other inefficiencies in develop- ing countries which have a similar effect. These inefficiencies in the allocation of existing resources have not so far been discussed. It is useful to make a distinction between inefficiency at the political-legislative level and two other types of inefficiency:

(i) political interference with the administration, and

(ii) administrative inefficiency.

77. It may be true that there is nothing more important in a LDC than will- ingness to pay taxes, but this willingness will be wanton without proper spending of the receipts. Jessee Burkhead has described the situation in developing coun- tries very graphically as one in which: "there is a shortage of accounting and administrative skills; t#ere are gaps in the hierarchy of government organization; there is an inadequate sense of personal moral responsibility for the conduct of government affairs."l/ Corruption is more or less rampant in most developing countries. In South Asia, for instance, it is reported "that those vested with official authority and power very often exploit their position in order to make a gain for themselves, their family, or social group. This is so whether that position is the high one of a minister, a member of the legislature or a superior official, whose consent or cooperation is needed to obtain a license or settle a business deal, or the humble position of a petty clerk who can delay or prevent the presentation of an application, the use of a railroad car, or the prompt opening of the gates over the tracks."2/ This is not a subject which, for obvious reasons, wfill be documented in lWorld Bank reports but to close one's eyes to its existence would equally obviously be absurd. Attitudes to taxpaying by the popu- lation will be related to the extent of misuse and waste by the government and their recognition of these inefficiencies (in the sense defined above).

Political interference

78. It is important that outside pressures are not brought to bear upon decision making by civil servants. All too often, however, it appears that

1/ Jessee "Wkhead? Governm6entrBiidgeting, Wiley & Sons, New York, 1956, p. 455. 2/ Gunnar Myrdal, Asian Drama, Twentieth Century Fund, New York, 1968, p. 948. - 3L4 - pressure from groups as well as from individuals, is used to seek benefits which are detrimental to the interest of the general public. Extremely wasteful spend- ing in times of election is a frequent practice in many countries. The Philippines is a case in point which illustrates the meticulous care with which disbursements of public works funds have to take place, particularly in election times, to prevent the misuse of funds (see Chapter IX, Case study on the Philippines).

Administrative inefficiency

79. Administrative inefficiency may be sub-divided into what we may call incompetence in administration and vested interests in administration. Incompe- tence in administrative procedures, in budgeting and in fund control, wfill slow down and delay the flow of funds in comparison with the expenditure allocation and timing originally decided upon by the legislature. Some public expenditures may increase over and above that which was legislated, whereas other areas will experience shortfalls. The presence of vested interests is another complication. Also in the literature there is support for the contention that public agencies or groups of public officials can themselves constitute interest groups.l/ Spe- cifically it is reported that in developing countries: "often the budget agency is stultified by lack of financial discipline in the administrative service. If ministers are a law unto themselves and do not have to take cognizance of finan- cial regulations, the country is likely to find itself with large expenditures for which no provision can be found."2/

80. 14here there are vested interests and corruption within the administra- tion, civil servants maximize their own gains to the detriment of the public interest. There is a wastage of public funds. In this situation, it happens that less than what is appropriated is obligated and less than what is obligated is warranted and even less than what is warranted is finally disbursed. But sit- uations may occur where more than what is appropriated by the legislature, say for a particular road construction, is disbursed because this brings benefits to the civil servant in charge of the road construction program. It follows that both corruption as well as administrative inefficiency, will be likely to intro- duce deviations, which may be substantial, from the expenditure allocations de- cided upon by the legislature. Even if all other conditions for the Lindahl model are satisfied, ex ante and ex post expenditures will differ. Optimality in the satisfaction of collective wants will hardly be reached. Another way of express- ing this is to say that the actual budgetary ratio for the allocation of expendi- tures upon the various expenditure categories will differ from the optimal ones.

Remedies - The role of earmarking

81. In order to limit the extent of corruption in India, the main theme of the recommendations of the important Santhanam Committee was,in so far as possible,

1/ Charles E. Lindblom, The Intelligence of Democracy, Op. cit., p. 13. For a further discussion, see Anthony Downs, Inside Bureaucracy (Chapter XI). "The basic nature of control problems in bureaus".) Rand Corporation Research Study. Little Brown and Company, Boston, 1967, p. 132. 2/ E. Himsworth, "Financial Administration in Developing Countries", No. 2, Finance and Development, 1968, p. 31. to limit discretionary powers. "''While we recognize that it would not be possible to completely eliminate discretion in the exercise of powers, it should be possible to devise a system of administration which would reduce ibthe minimum, even if there is a certain seeming loss bf perfection, the need for exercise of personal discretion consistently with efficiency and speedy disposal of public business. "11/

82. Earmarking limits the discretionary powers of politicians and officials in line with the recommendations of the Santhanam Committee. Earmarking means a specialization of the budget. It can be argued that separate accounts are likely to bring about a stronger shield against attempts from politicans to influence the expenditure allocation. In fact, the earmarking of revenue often takes place simultaneously with the setting up of a public or semi-public agency e.g., a development board or a plan organization, which allows an even higher degree of insulation from undesirable interference. Wqith regard to adminis- trative inefficiency, earmarking can be used as a means to foster compliance witn the initial appropriations. Through the segregation of accounts, bookkeeping and auditing of funds could be facilitated, which would contribute to less fraud and anomalies in accounting.

83. Rapid inflation may be an additional factor contributing to the use of earmarking. Frequent earmarking in Brazil may be explained partly on these grounds: "Instead of relying upon the vagaries of the budget process, earmarking benefits from a revenue base shat responds automatically, in many instances, to changes in the price level." 2 /

84. The situation is complicated because it can be argued that an insulation of revenue might not limit inefficiencies and corruption, if this phenomenon occurs not only at the central budget office but also at the executive or operation- al level. Even if there are good reasons to believe that earmarking nould clear the funds through the central budgeting office, political interference and administrative inefficiency could still influence the final expenditure alloca- tion. There is a dilemma. One way out is to earmark not just for function, but for individual projects. But this extremely specific earmarking arrangement aggravates the danger arising from a fixed resource allocation. In the case of highways, for example, it sometimes appears that individual projects have separate earmarked accQunts and this represents a degree of inflexibility in the budgetary system which it wouldbe hard to defend except in very extreme circums- tances.

1/ Government of India, Ministry of Home Affairs Report of the Committee on Prevention of Corruption, New Delhi, 1964, p. 45. (This Committee is referred to as the Santhanam Committee, after its Chairman). For a futher discussion, see G. IMyrdal, 1968, Op. cit., p. 755.

2/ Un-issed Draft Research Report on The Mobilization of Financial Resources in Brazil, IBRD Economics Department, 1966. - 36 -

85. In Iran, the opposite is true. Oil revenue is earmarked, not for particular expenditure purposes, but to the Plan organization which plans and administers Plan investment.l/ This "open-ended" earmarking has not been able to prevent waste and distortion in the final expenditure allocation of ministries to the extent possible. The Iranian case suggests that when there is earmarking for a broad end purpose, such as a development plan, the earmarking will remain partly ineffective if, firstly, there is inadequate political support for the earmarking, i.e., a part of the earmarked revenue is not transferred. In other words, a distinction can be made between a de jure and a de facto earmarking arrangement. Secondly, with regard to the use of earmarked funds, the allocation of earmarked funds is no solution to the problem of an inadequate scrutiny of the precise use of thse funds. The failure of the Plan organization to adequately scrutinize its allocation to ministries and agencies has contributed to the waste and distortions in the investment expenditure. 86. In spite of these deficiencies, in Iran earmarking is upheld as a useful instrument to increase the development effort. It is believed that in the absence of earmarking more funds would have been wasted or diverted to non- developmental expenditures. But it is clear that earmarking like other instruments of fiscal policy is no panacea. It will leave some room for administrative discretion in the final dicbursement of funds. This discretion is, of course, greater, the more open-ended is the destination of the earmarked funds.

A Bias Against Developmental Goods and Services in the Budget Making?

87. Above we have discussed inefficiency in administration and deviations in the allocation of funds under general fund financing. When budget allocations originally decided upon by the legislature are not effected as a result of the imperfections outlined above, the budgetary ratio between different expenditures deviates from the optimum. In other words, in a two public good model, one of the public goods will be differentially favored. IJe have argued that some at least of these inefficiencies can be erased by the adoption of earmarking in the place of general fund financing. With this assumption, it can be proved that group A, whth supports public services with an elastic demand stands to gain by maintaining general fund financing, if the budgetary deviation favors the service it supports (see Annex to this Chapter for a full discussion).1/

1/ It is noteworthy that in 1957 one of the IBRD programi loans of $75 million was directed to the Plan organization. Its purpose was to provide tempor ary financing to carry out programs and projects which would be delayed because of a lack of funds before oil revenue started to materialize.

2/ Elasticity of demand for the supply of public goods and services is defined in terms of tax burden -- the tax prices a group of voters is willing to pay to obta different quantities of a public good. - 37 -

But on the other hand, if the budgetary distortion favors the demand inelastic service, group A is in favor of a shift from general fund to earmarked finance. It was showm that if the direction of the budgetary deviation is unknown, group A should rationally opt for earmarking. Our purpose is now twofold: Firstly to determine the likely direction of the budgetary deviation. Will this deviation favor developmental or non-developmental goods and services? Secondly it becomes crucial to determine which is relatively more demand elastic, develop- mental or non-developmental goods and services? To begin with, it is necessary to determine whether the budgetary deviations favour or disfavour developmental goods or services.

88. It is, firstly, not hard to find examples of self-interest or government officials. Typical examples of self-interest are cases of inflated salary increases and other benefits for civil servants, which are not necessary for market reasons. Both Brazil and Peru, are cases where the growth of current expenditures especially salaries, has repeatedly got out of control. In the field of defense, many governments in developing countries seem to condone rapidly increasing expenditures, not necessarily on account of strategic reasons but simply to placate military groups. In Peru, there is even an earmarking of import duties for defense purpose. 89. Secondly, ostentatious public luxury consumption seems widespread. It is reported that "in several new countries, large sums have been spent on extravagant office buildings and schools or on lavish2y appointed show piece palaces instead of on productive projects."tl/ Arthur Lewis has noted that the weakness for prestige ... "shows itself not so much in the objects of expenditure, which are desirable in themselves, but in doing on a lavish and magnificent scale what could be done much more cheaply, and especially in lavish expenditure on airports, model towns and improving public buildings ... I would give high marks to a development progran in which only 10 percent of the expendibure was in nonsense of this kind, whereas a program in which the figure reached 30 percent would seem to be well below par.i"2/

90. Thirdly, more administrative competence and planning is required to execute and implement expenditures of investment character than those of a trans- fer nature. In other words, because of the ease with which current spending and particularly of a transfer nature, can be administered compared with other expenditures, there is an additional bias in favor of this type of expenditure. Particularly in many Latin American countries, it appears that the share of current spending is displaying a rising tendency. The comtbined evidence attests to the fact that budgetary deviaticns, from the original spending pattern laid down by the legislature, i likely to have a bias in favor of current expenditures, and in par- ticular those of a non-developmental character. In other wQrds, there will be an under-provisicn of expenditures for development, of capital as well as current ex- penditures.

1/ A. Waterston, Op. cit. p. 105 2/ Arthur Lewis "On assessing a Development Plan" p. 10. Quoted in Waterston, Op. cit. p. 105. - 38 -

Earmarking Promotes the Development Effort

91. The aUlocation of resources is likely to deviate from the appropriations agreed upon by a majority of lawmakers. It can be asserted that the budgetary ratio under general fund financing will tend to deviate in favor of non-develop- mental expenditures. From the theoretical analy8is, it-emerges that to spel out the effect of a shift from general fund financing to earmarking with respect to total public outlay, a knowqledge is required of how the demand for non- developmental expenditures and conversely for developmental expenditure behaves with respect to price changes for these public goods (See Annex to this Chapter).

92. What is a unit of a public good or service? Once a "unit" is defined, it is possible to discuss what effect a change in this unit cost would have upon the demand for this service at a given tax distribution. Developmental and non-developmental expenditures are concepts of such aggregate nature that a discussion of relative elasticity of demand becomes difficult. Instead the individual components of developmental expenditures such as investment in transportation, power and education can be contrasted with, say, defense expendi- tures. With respect to transportation, there is no problem in defining a unit of highway investment; typically, it might be a mile of paved road of a given width and standard. In the case of defense, a unit may be an army brigade. Suppose that both the cost of constructing a mile of paved road and the cost of a brigade decrease by 50 percent. It would appear that the demand for road works would be much more elastic than for army brigades, in particular if the size of thearmy is related to strategic considerations, such as the possibility of aggression.

93. For the purpose of the present exposition, let us accept the thesis that developmental expenditures generally are relatively demand elastic with respect to price or unit cost, compared with non-developmental expenditures. This granted, there are convincing reasons for the groups supporting developmental expenditures to favor a conversion from general fund to earmarking. Excess allocation of resources for non-developmental purposes will firstly be made not only more difficult but, secondly, expenditures upon development for roads, education, etc., will expand.

The Bureaucracy -- To Reach Agreement to Shift to Earmarking?

94. It may not be easy to do away with inefficiency in the form of poli- tical interference in the 'administrative machinery and vested interests among officials. The bureaucracy itself is not a disinterested group, for which reason it will generally try to prevent a shift to earmarking. As we have seen, earmarking compared to general fund financing means the impositon of a cons- traint in the decision making of the bureaucracy. Legislating a shift to earmarking -- a political decision -- presupposes that there be a consensus among a group majority in the legislature, to do away with any advantages, which may arise out of the interference with the administration. Again it has to be demonstrated for a majority coalition, that an erasing of inefficiencies through using earmarking will bring forth a net gain for this majority. In this respect, there is no difference with the previous case of unstable majority coalitions where earmarking was seen to be the precondition for arriving at a tax-expendi- ture decision. - 39 -

95. In this situation it would not be unrealistic to assume that the bureaucracy might retain a control over the execution of the political decision making, strong enough to prevent a shift from general fund to earmarking. The contracts agreed to by the legislature would not be enforced. In this case help in enforcement, coercion, why not from the World Bank might produce a Pareto- optimal solution in line with the true preferences of lawmakers. In fact, it can be shown that coercion or earmarking woiuld turn out to be the optimal solution evenforthebureauracy. Simple game theory may help us to see this. Let us assume that the country has a budget of $100. Two bureaucrats I and II have to spend $50 each. Suppose the marginal benefit or utility to the community of each dollar spent, if both bureaucrats act altruistically is 4 and constant in relation to the amount spent; on the other hand, if both bureaucrats cheat, the marginal utili- ty to the community is 2. In other words, each bureaucrat makes a private gain of $25. Figure 2

liarginal 4 Utility

! 2

-___ Public expenditure

96. This means that at a budget of $100, if both men act altruistically, the payoff to the community is 400 in terms of utility. If both bureaucrats have no concern for social values and cheat, each bureaucrat will spend $25 instead of $50 and use the odd $25 for his own benefit. The total utility payoff to the community becomes ($100 x 2) = 200. The following 2-by-2 matrix illustrates the outcome and the options. The upper number in each box gives the gain in $ to Figure 3 BUREAUCRAT I

Altruistic Cheat (0) (25) Altruistic 100 300

BUREAUCRAT II (0) (0) (0) (25)

Cheat 300 200

(25) (25) - 40 - bureaucrat I of cheating, the lower number gives the similar gain in $ -to bureaucrat II. The middle number in each box show the community payoff. The matrix exemplifies the classical Prisoner's Dilemma form.l/

97. If both bureaucrats act only with their own individual gain in sight, without regard to community welfare, both will cheat. Each bureaucrat will make a private gain of $25. But in this position, since both I and II are citizens of the community they will, of course, share in the community utility payoff of 200, instead of 400 every citizen would have enjoyed were the full 100 spent upon public goods and services. It is assumed that these public goods, e.g.,. defense and fire protection, are of equal benefit to each citizen. Each bureau- crat's gain, therefore, is 200 plus the $25 in money value. To translate the pecuniary gain of each bureaucrat into utility units, we multiply $25 with 4, which is the society's marginal benefit of $1 actually spent. The payoff of cheating to each bureaucrat becomes $100. In turn, the total utility of each bureaucrat becomes (200 + 100) = 300. It is at once clear that it would have been in the true interest of both bureaucrats, as well as of the community, if both bureaucrats had been non-corrupt; in other words, if both from a strictly individualistic point of view had acted irrationally. In this case, the utility payoff to everybody would have been 400.

98. To make this model and the conclusion we derive from it more realistic, suppose that the public sector instead of 2 comprises 20,000 bureaucrats. It is assumed that each one again shall spend $50. Analogous to the previous case, if each bureaucrat is corrupt, he spends only $25 and consequently makes a private gain of $25; public expenditure becomes $500,000. On the other hand, if there is no corruption public spending doubles to $1 billion. Obviously, it has be- come much more appealing for each bureaucrat to stop cheating, if everybody else does the same, in the situation where the public sector consists of 20,000 in- stead of 2 bureaucrats. If each offical forfeits his "gratuity" of $25, he as well as all other citizens, would receive the benefits of an additonal spending of $500,000 upon public goods and services. To conclude, the imposition of some form of external coercion or constraint against cheating such as earmarking would make everybody happier, in fact even the bureaucrats.

Savings through Taxation -- A Reality or Mirage

99. Is there a bias against development in the political decision making? Recently amongst those concerned with economic development, increasing attention has been given to the awkward possibility that when governments increase their tax revenues, this may be associated with increases in public consumption rather than in public savings. Non-developmental expenditures will be favored over those of a developmentAlnature.This is the so-called "Please" effect.2/ Twro studies analyzing the public savings and public consumption perforr,unce of a cross-section of developing countries have thrown up evidence which give more qualified support to this hypothesis,, or at a minimum, do not deny its

1/ The idea to illustrate the problem with a game theoretic illustration was given to me by Dr. Charles J. Goetz. For a further discussion of the Prisoner's Dile- mma, see "Paper on Non-Market Decision Making II." The Thomas Jefferson Center for Political Economy, University of Virginia, Charlottesville, 1967, p. 1. 2/ Stanley Please, "Savings through Taxation -- A Reality or Mirage", Finance and Development, Vol. IV, No. 1, March 1966. - 41 -

validity.l/

100. However, -mOe ^onclusive evidence for the Please hypothesis has recently become available. Lotz examining a cross section of 37 developing countries with a GNP per capita of less than $800, found that as the ratio of taxes to GNP increases, the additional revenue is spent upon non- evelopmental goods and services. Developmental expenditures do not increase.- When taxes increase clearly expenditure for social needs and defense have a priority, not econo.nic services. Even while this behavior can be explained on account of vested interests and lack of competence within the bureaucracy, and political inter- ference into government affairs -- which is the case we dealt with above -- there may be other reasons such as unawareness or inadequate attention at the political level to the importance of savings or ignorance of the mechanism of development.

1/ Krishnamurty: "Savings and Taxation in Developing Countries", An Empirical Study. IBRD Economics Department Wbrking Paper No. 23.

Elliott Morss: Fiscal Policy, Savings and Economic Growth in Developing Countries. D.M. 68/43 fl4F. The latter paper appears to present empirical support to refute the "Please" hypothesis, but it can and has been interpreted as lending support to this hypothesis. (See critical memorandum by John Holsen on the M!orss analysis, dated August 5, 1968.)

2/ Joergen Lotz, "Patterns of Government Spending in Developing Countries -- An Empirical Study". (Forthcoming flF paper). The relevant equation has been calculated on the basis of data presented in this paper. 2 S = 0.425 4 - 0.01429 T R = 0.000 (0-1093) y

where: S taxes less expenditure mn non-economic services. Expenditures upon non-economic services is the difference between total government expenditures and current, capital expenditures and lending for economic services,(e.g., agriculture, industry,.commerce transport and communication, etc.)

T total taxes as a percent of MR. - 42 -

For instance, citizens may be more willing to be taxed for expenditures on social needs, from which they derive immediate benefits, in contrast to investment projects with long gestation periods. This situation is fundamentally different from the previous one, where it was assumed that the peoplels representatives, the lawmakers legislated, but that their decisions were not enforced due to a recalcitrant bureaucracy. It is clear that when votes favor public consumption over public savings, there is no basis for talking about budgetary deviations. The electorate itself allocates public expenditure according to its preferences. The Lindahl model will not hold since as we have seen in this theory, the voters express their own preferences for public goods. Under certain constraints an optimal satisfaction of collective wants will be produced. If there is a political bias, against an adequate public savings performance -- however defined -- and external values are imposed to correct for this, social goods are no longer supplied in line with group preferences. In our theoretical analysis of the Lindahl model, it was concluded that in this case, there is no optimal solution of the model (See Annex to Chapter II). Moreover; the proof of the necessity of implied or explicit assignning of revenue or earmarking no longer holds.

101. Do we have to scrap the Lindahl theory wihen external values are imposed into the democratic decision making? A solution has already been referred to. Rational choice requires an acquaintance with alternatives;therefore, a temporarily imposed choiy/ in the form of persuasion may be justified as an aid to the learn- ing process.- In fact, the necessity of "learning" is amply illustrated by the application of the Prisoner's Dilemma to the bureaucrats' decision making. Yur model showed that when both persons concenied themselves with their narrow private gain, disregarding. social values, coercion could improve their utility and the community's utility position. The same situation could apply to a whole community, where political groups in a narrow pursuit of self-interest do not perceive the possible benefits of increasing aggregate savings in the community. 102. The education of the electorate by the "chosen" can simply be re- garded as a short-term deviation from the long-term accommodation of collective wants through the political decision making. How will agreement be reached on a shift from general fund to earmarking? It is clear that political groups must be persuaded that public consumption must be curbed to improve an inadequate public savings performance. A second possibility is that external lending, including the World Bank, help "pro development groups" to reach a consensus which puts greater emphasis on development as a national goal as opposed to other goals of the society. We suggest that this interference be regarded also as a learning effect, as a short-term deviation from the previous assumed optimum satisfaction of collective wants. Hence the assumption of the basic theory would not be invalidated.

1/ Richard A. Mlusgrave, 1966, Op. cit., p. 17. ANNEX Page 1

ANNEX CHAPTER VI

CHANGES FROM GENERAL FUND TO EARMARKING - A THEORETICAL ANALYSI3

1. The discussion of this Chapter on inefficiencies can be examined more precisely by theoretical analysis. This is undertaken in the remainder of this Annex. Two distinct cases are considered. Firstly, where through slowness, delays, etc., in project financing, unit costs per quantity of a government service supplied will be increased. To produce a given quantity of the public good, more time is necessary. Even if the cost of time were zero -- which it is not -- the cost of unused capital is not zero. For instance, in the case of road wvorks, through delays in financing, heavy machinery and equipment will have to remain partly idle, when this equipment gainfully should have been used elsewhere. Road construction unit costs will increase.

2. The second distinct case to be considered is where unit costs of the public goods supplied are not affected, but where the budgetary allocation, for the amount of funids to be spent on each of the public services is different from that voted and decided upon by the legislature. W4hat is examined in the following analysis is the effect of a conversion of existing general fund taxes for financing twio services, to an earmarking of revenues for this purpose.

Reduction of unit costs

3. The purpose of the present analysis is to show that in the absence of earmarking, when there is inefficiency;-in public sector operation, a smaller amount of public expenditures will, under certain conditions, be derived. In other words, reverting once again to Figure 1, p. 25, there is a second reason wrhy movements from P1 towards PO -will be encouraged by the use of earmarking.

Unit Cost Figure 3

Q

C1 F1

C2 - 2

C0 F0

CO.__ . ____

X G _ fQuantity GI G2 Go of G, ANNEX Page 2

4. When the unit cost of G increases from C. to C1 , less of G, will be demanded. If the elasticity of demand for G, is more than unity, expenditure upon G- will decrease. If other expenditures do not increase, there will be a tax reduction, since the marginal utility of consumpticn of private goods and services, relative to consumption of q increases. We will assume that the introduction of earmarking reduces unit costs from Cl to C2 . If, as we assumned above, the demand is elastic over the relevant rarnge, the introduction of earmarking will generate a demand for increased taxation to finance increased public expenditures on G-. However if the demand is inelastic, a higher quan- tity of G, will be demanded, but public expenditure wTill decrease. Ceteris paribus, there should be a tax reduction. A more realistic assumption might be that the freed surplus can be used for spending elsewhere in the public sector. Total public spending will remain constant, but tax payers' satisfaction will have increased.

5. Thus, ceteris paribus, when earmarking replaces an existing general fund financing for a public good if the unit cost decreases as a result and if the demand is elastic over the relevant range, public expenditure will increase. Returning to Figure 1, we have noted that P is preferable to P1. lihether the additional expenditure should be earmarked 8 r not will depend. If no revenue will be raised in the absence of earmarking, earmarking is the preferred solution.

6. Let us now introduce another public service G2. The demand for a, is elastic, but not for G2. On the assumption that there are two voting groups, each supporting one of the two public goods, which group will be most interest- ed in converting existing general fund financing to earmarking? From the above discussion it emerges that both groups will support a conversion from general fund to earmarking. As a result of the unit cost decrease, the group in favor of the demand elastic service, will be willing to increase its tax burden in order to increase public outlay on G,. On the other hand, for the group supporting G , the shift means eithe5 a tax reduction or the possibility of allocating their "surplus" to other functions.

Change in budgetary ratio

7. Let us turn to the second case, wqhere unit costs of the public goods supplied are not affected, but where the budgetary ratio or the allocation of funds, under general fund financing, deviates from the original allocation by the legislature as a result of the inperfections outlined above. In other words, one of the two public goods will be differentially favored. In this situation, it is assumed that a conversion to earmarking brings about a return to equilibrium to the original expenditure allocation of the legislature.

8. There are two groups, A and B. Group A is in favor of public good G-, and group B in favor of public good G2. Again suppose that the demand for good G, is elastic and for G2 inelastic. Let us now assume that the budgetary ratio is 40:60 for G and G2 , respectively, and the general fund budgetary ratio is 50:50, good GC will be favored compared with the original allocation ratio. Conceptually, this is the equivalent to a situation in which the relative price of Gl is assumed to fall. More of GC will be demanded. Because of the symmetry, when G, is favored, Go must be disfavored. We can assume that the price for GC decreases from 174 to 1/5 whilst the price for G2 increases from 1/6 to 1/5. For a given amount of revenue, more of good G ANNEX Page 3 and less of G2 will be purchased.

9. When earmarking is introduced there will be a return to equilibrium to the budgetary ratio originally fixed by the legislature. The direction of change of total public outlay will depend upon the configuration of the demand functions. If, as assumed, the general fund budgetary ratio favors the service G1, where the demand is elastic at the full equilibrium quantity, there will be a decrease in the quantity demanded and in the spending upon G1 when there is a shift to earmarking. There will be a small increase in the quantity con- sumed of G2 but spending upon G2 will fall. Total public outlay will decrease.

10. On the other hand, if the budgetary ratio under general fund financing favored the public service with the less elastic demand, at the full equilibrium quantity, the effect of the earmarking will be different. Both quantity and outlay on Gi lLl increase. The quantity of G2 falls, but outlay on G2 increases, %ecause of the inelastic demand for G2 . Total public outlay will increase. However, these results are valid only for limited shift in the ratio away from the full equilibrium.l/

11. What is the implication for group behavior? Firstly, when under general fund financing the budgetary deviation favors q~ , the demand elastic service, there was a decrease of total public outlay by shifting_to earmarking. The group supporting G1 is likely to be negative to the idea of earmarking. But the pressur-e group for the demand inelastic service stands to gain. Since part of the tax revenue collected from this group was used to finance G1, and this exploitation has ended, this group may claim-n a tax reduction.

12. Secondly, when the budgetary ratio under general fund financing favors the demand inelastic service G2, both the quantity and outlay on G will increase through the shift to earmarking. As a result, group A in }avor of , will strongly support a shift from general fund to earmarking. This situation is similar to the one previously discussed with reference to Figure 1. Group A finds itself at point P1 and in order to obtain increased public outlay and to proceed towards PO, the optimal point, group A will have to accept a higher relative tax share or a higher distribution ratio, i.e., the condition h: h,, must be satisfied in order to increase public expenditure towards the optiraum. On the other hand, the group supporting G2 will be forced to reduce somewhat its consumption of G2, but not proportionally to the increased supply of good G.. Spending upon G will increase because of the inelas- tic demand for G2. Similar to the situation in Figure 1, group B will pay for a higher magnitude of public expenditure, but at a smaller distribution ratio.

13. We conclude that graup B will be relatively indifferent compared with group A, as to earmarking versus general fund financing. If the budgetary ratio under general fund financing should favor service G2, the degree of exploitation of "taxpayers' surplus" on service G1 is rather limited. On the other hand, should the deviation favor G1, the risk of group B being exploited is substantial. Group A, in contrast, will have a strong interest in maintain- ing general fund financing, wihenever the budgetary deviation is in its favor. Group A would be equally adamant in asking for a conversion from general fund to earmarking when the budgetary deviation, to the same degree, favored service G2 instead of 01.

1/ For a further discussion and a geometrical presentation, see J.DL Buchanan: 6 "The Economics of Earmarked Taxes," Journal of Political Economy, 1963, p. 4 3. ANNEX. PageI4

14. Is there then a symmetry here so that it is not possible in t:ie case of group A to state whether it is more in favor of earmarking than general fund or vice versa? In fact a clear answer can be given. So far in this discussion of deviations in budgetary ratios resulting from imperfections, political interference, corruption, etc., in the administration, we have not considered the possibility of reductions in unit costs per se because of earmarking (this discussion took place in the preceding sectio7n.-Let us include a reduction in unit cost through earmarking in the analysis, as well as the shifting of the budgetary ratio back to equilibrium.

15. By assumption, when general fund financing is retained, there will be no decrease in unit costs. But in this case when the budgetary deviation favors G2, there will be an additional outlay on , when earmarking replaces general fund financing, because of the reduction in unit costs. Therefore, if the budgetary deviation in favor or in disfavor of G, under general fund financing is equally large, and there is a toss up whettier the deviation would favor the demand elastic or inelastic service, group A should opt for earmarking because of the probability of a higher payoff. CHAPTER VII EARNMARKING FOR HIGHWAYS IN DEVELOPfIG COUNTRIES - AN EMPIRICAL STUDY

103. Originally our study on earmarking started with an analysis of the practice of earmarking taxes for roads in developing countries.S/ The object was to test empirically the connection between earmarking and re- source allocation. The study covered the time period 1955-65 and was restricted to developing countries.2/ With data both from countries, which earmarked revenue to highways and those which do not, the study set out to establish if there is ary relationship between total expenditure on roads, as a proportion of gross domestic capital formation, and:

(a) the existence and non-existence of earmarked revenue for roads; (b) earmarked taxes for roads, as a proportion of gross domestic capital formation.

104. It can be argued that earmarked taxes for roads, as a proportion of public investment, instead of a proportion of gross investment, would have been a more operational concept. Gross investment rather than public invest- ment was chosen, because:

(a) the problem of variations in the scope of the public sector in the total investment aggregate is avoided; and (b) data are more readily available for gross investment than for gross public investment.3/

105. Negatively it should be emphasized that the study did not purport to examine whether investment in highways had been optimal or not. The question of road user charges and their relation to road expenditure was also outside its scope. Earmarked taxes and user charges differ firstly since road user charges are not necessarily earmarked for road development, and secondly, because taxes earmarked for roads are not always charges upon road users, although the latter does appear to be most common.

Survey Results

10o. Ideally, we would have wished 10-year time series for the.perivid 1955-65 to have been available for all countries. However, data of this

See Per Eklund IBRD Economics Department Working Paper No..1, June .1967.

2/ With the exception of New Zealand.

3/ Accurate data on gross public investment are frequently not available because of poor data of entities in the public sector outside the realm of the central government. Gross investment is often directly estimated from the flow of commodities in an economy, without distinction as to private and public sectors. coverage were available only for a limited number of countries. Acceptable data for the cross section analysis were found for 18 countries which have earmarking for highways, and for 19 non-earmarking countries. For each country and for each year, for which observations were obtained the percen- tage of road expenditure to gross investment was calculated. An average for the period was then taken for each country covering the period for which observations were made. This was done both for the non-earmarking and the earmarking countries. For the latter, the average percentage of earmarked taxes to gross investment was calculated in the same manner.! y/

107. The survey showed that altogether at least 31 developing countries had or initiated legislation for the earmarking of taxes for highways in the period 1955-65., although lack of data restricted the study to the examina- tion of 18 of these countries. Earmarking for highways is more common than first expected. It is wJidespread in South America where ten countries were found to have earmarking for this purpose. However, in Central America, Costa Rica is the only country which employs earmarking. Earmarking is widespread in former French-ruled Africa, where nine earmarking countries were found. Earmarking is less common in former British ruled countries in Africa. In Egypt, earmarking still takes place, but it has been dis- continued in Ghana, Kenya and Uganda.

108. The percentage of earmarked taxes to highway expenditure varies considerably in the earmarking group with a mean proportion of 37 percent. Peru comes closest to a 100 percent caverage with a mean of 88 percent, followed by Ethiopia and New Zealand with 68 percent and 62 percent, respec- tively. The residual element of expenditure on roads in the countries was met out of external aid, and/or allocations from the general budget.

Earmarking and Non-Earmarking Countries - Cross Section Analysis

109. The 18 earmarking countries were compared with the 19 in which no earmarking existed. Is there any significant difference in the ratio of road expenditure to gross investment between the two groups? For the earmarking countries, the average percentage of highway expenditure to gross investment

1/ Fiscal years do not agree everywhere with calendar years. Thera should be little harm to the analysis, particularly since averages for the period are used in the cross-section analysis. 2/ The means were also calculated by the alternative method of taking the percentage of accumulated road expenditure to accumulated gross invest- ment, over the period. There was no significant difference in the mean proportions of road expenditure to gross investment obtained by the two methods; the two means of earmarked taxes to gross investment were identical for the sample of earmarking countries. is 9.9 percent with a standard deviation of 5.6.1/ The aver.dge for the non- earmarking group is lower, 8.1 percent with a standard deviation of 4.2. The average per capita incomes are nearly identical in the earrarking and non- earmarking group with means of US$287 and US$291 per capita, respectively. The median income in both groups is about US$200. It follows thalt the comparison between the two groups is no-t biased on account of disparities in average in- comes.2/

110. The difference in the mean proportions brings with it the suggestion that the ratio of road expenditure to gross investment is in general higher in earmarking, than in non-earmarking countries. However, statistically the difference is not significant.3/

111. No appreciable difference in the average incomes was found between the two groups. But is there any difference in the relationship between GDP per capita, and road expenditure as a proportion of gross investment, between the two groups, which might be attributed to the existence of earmarking? For the earmarking group the correlation is 0.0; for the non-earmarking group it is -0.30 There is a difference, but it is not significant.y However, for those who do not put their entire faith into significance testing, the difference might suggest some support to the thesis that earmarking imparts rigidity into the allocation of funds in favor of the earmarked function. A negative correlation for the non-earmarking countries suggests that normally the ratio of road expenditure to gross investment decreases with rising income levels. This may reflect in part the fact that a definition of road expenditure is used which excludes urban street and road expenditure. Moreover, it might also reflect a fundamental relationship between road expenditure and rising per capita incomes.

Earmarking countries

112. How is the relative allocation of funds to the road sector influenced when the earmarked revenue varies as a proportion of gross investment? The cor- relation coefficient between the ratio of road expenditure to gross investment and earmarked taxes for roads as a percentage of gross investment was found to be 0.72. The correlation coefficient is significantly different from zero at the one percent level (See Annex II). In other words, as earmarked taxes for roads are

1/ Within the earmarked groups, Madagascar has by far the highest ratio of high- way expenditures to gross investment, 28.3 percent. When Madagascar is left out, the difference between the two groups becomes less marked; the mean for the earmarking countries is 8.8 percent with a standard deviation of 3.3. 2/ GNP per capita at factor cost obtained from IBRD WMorld Economic Tables, Nov- ember 1966. 3/ The difference between the two samples was statistically tested with the t- distribution, to determine whether the mean of the population of earmarking countries is significantly different from that of the population of non-ear- marking countries. It wqas assumed that the proportions of road expenditure to gross investment are normally distributed and secondly that the variances for both populations are equal. The hypothesis that the two populations have the same variations was tested and found justified at a significance level as high as 20 percent. 4/ The difference between the two correlation coefficients is not significant at a significance level of 5 percent. increased in a country, and more than the increase in gross nvestment, it appears to be the case that the highway sector receives a higher pro, ortion of total in- vestment. Since the regression coefficient is 1.5, the relaiionship can be ex- pressed: When earmarked taxes for roads increase (decrease) ;)y one percent in re- lation to gross investment, this is associated with an increase (decrease) in the proportion of road expenditure to gross investment of 1.5 percent.

113. Is there a causal relationship here? To postulate this, would implicitly assume that all relevant variables, except for earmarked taxes as a proportion of gross investment, behave identically in the earmarking countries. The correlation between GNP per capita and road expenditure as a proportion of gross investment was found to be zero. There does not appear to be any meaningful relationship between earmarked amounts as a percentage of gross investment and GNP per capita. Richer earmarking countries do not earmark rela- tively more (less) than poor ones. There is also no evidence that vehicles per capita bear any relationship to road expenditure as a proportion of gross invest- ment.l/ For these reasons, it is safe to say that different levels of income, measured either in GNP per capita or in vehicles per capita, do not bring in any distortions into the examined relationship, which might modify the conclusion, that there appears to be a causal relationship between a higher proportion of earmarked taxes to gross investment, and a higher proportion of road expenditures to gross investment.

11,. It is clear how the causality works, when earmarking covers 100 per- cent of road expenditure and earmarked taxes are the single source of funds, domestic as well as external, for highway expenditure. The two percentages become identical, since gross investment is the common denominator. When ear- marking increases as a proportion of gross investment, the ratio of road expendi- ture to gross investment wfill grow with the same proportion. But what appears bothersome to explain in the first instance is that the average percentage of earmarked taxes to road expenditure for the 18 countries in the earmarking group is only 37 percent. Although earmarked taxes only cover a part of total road expenditure, does a mere existence of earmarking function as a guarantee for a higher investment plateau in the road sector? (This question is taken up later 2/. Time series analysis

115. Time series of sufficient length and reliability were found for five countries to test the relationship between earmarked taxes as a percen- tage of gross investment, and road expenditure as a percentage of gross investment. For these countries, Brazil, Ethiopia, Kenya, New Zealand and Peru, the fitting of a straight line to the data was justified. The cor- relation coefficients are 0.84, 0.89, 0.99, 0.83 and o.65, respectively; all are significantly different from zero at the one percent level. The weighted mean of the regression coefficients is 1.7.3/ The subsample is small.

1/ This relationship was tested for the earmarking countries. The correlation coefficient is zero. The data for vehicles per capita for 1960 were obtained from U.N. Demographic and Statistical Yearbooks. 2/ See paras. 125to 129 (below). 3/ Weighted by number of years. - 47 -

Nonetheless, on the basis of the time series for these five countries, it is demonstrated that 'jhen earmarked taxes increase (decrease) by one percent in relation to gross investment, road expenditure as a proportion of gross in- vestment increases (decreases) by 1.7 percent. This result does compare very favorably with the relationship 1:1.5 obtained in the cross section analysis. The unweighted mean of earmarked taxas to road expenditure for these five countries was 63 percent, which is substantially higher than the 37 percent obtained in the cross section analysis. Countries wkich initiated or discontinued earmarking

116. Countries were also studied which started or ended their practice of earmarking to determine what impact this had on the percentage of road expenditure to gross investment. Again the data made it possible to look at five countries. Kenya, Madagascar and Mauritania discontinued earmarking for roads, whilst it was started in Chile and Costa Rica. Kenya discontinued its practice of earmarking for highway expenditure in 1962/63. In fact, an IBRD recommendation had been made to this effect./ The percentage of road expenditure to gross investment fell from 13.4 percent in 1962 to 8.0 percent in 1964. In 1965, it had increased to 12.7 percent, the same as in 1961. Gross investment also fell absolutely in these two years largely because of uncertainty in connection with the declaration of independence. Althouph this instability blirs the picture there appears to be a ccnnection between the abolition of earmarked taxes and the subsequent fall in road expenditure.

117. In Madagascar, the road fund was discontinued at the end of 1963. In 1964, the percentage of road expenditure to gross investment fell from 29.3 to 26.3 percent. In lvauritania with the end of the Federation of French West Africa in 1959, earmarking for roads ended. From 1959 to 1964 the ratio of road expenditure to gross investment fell from 12.9 percent to 2.7 percent with a drop to 0.5 percent in 1962. Road expenditure even de- clined absolutely despite a sharp increase in gross investment.2/

113. In Chile, earmarking of taxes started at an appreciable scale in 196th. The percentage of road expenditure to gross investment increased to 10.2 and 10.4 percent in 1964 and 1965. The highest percentage in the previous years had been 9 percent. In Costa Rica specific taxes designated for highways were st up in 1961 for the Plan Vial. The arrangement was endorsed by the IBRD.- The percentage of road expenditure to gross investment rose from 4 percent in 1960 to 10.2 percent in 1963.

/ It was argues that because of the budgetary situation, the arrangements for meeting maintenance costs should be decided annually by the Govern- ment, rather than by allocating receipts from specific taxes to the road fund. IBRD, the Economic Development of Kenya. Report from Survey Mission, December 1962, p. 131. 2/ An attempt to set up a new road fund was made in 1964. Legislation was passed, but the arrangement never worked. 3/ A condition of the Highway Loan Agreement of 1961 was that the local currency portion of the program be provided by the taxes specifically designated for that purpose The usual rigidity of earmarking arrange- ments appears to have been circumvented, since the funds set aside must be appropriated each year by the Legislative Assembly. Transportation Consul- tants Inc., Washington, D.C., Central American Transportation Study 1964-65i, Vol. 1, p. 129. - 48 -

119. There is a clear correlation between the introduct..on of earmarking and a higher relative level of road expenditure, and between the discontinuance of it and a fall in the percentage of road expenditure to gross investment. Longer time series and more cases would have been desirable to make us more confident to this relationship. Still, the picture is sufficiently clear to support and not contradict the thesis that earmarking for roads is associated with a higher relative allocation of funds for this function, than when ear- marking does not take place.

Summary of findings

120. The analysis showed that:

i) Earmarking countries have a higher proportion of road expendi- ture to gross investment than the non-earmarking. There is a difference of 1.8 percentage points. ii) The correlation coefficients between GiP per capita and the proportion of road expenditure to gross investment is zero for the earmarking and -0.3 for the non-earmarling countries. iii) There is a positive correlation between earmarked taxes as a proportion of gross investment and road expenditure. Both the cross section and the time series analysis attest to the existence of a positive relationship. iv) The time series for the earmarking countries showed that there is a clear correlation between the introduction of earmarking and a higher relative level of road expenditure, and between the discontinuance of it, and a fall in the percentage of road expenditure to gross investment.

121. Three of these independent tests pointed in the same direction that earmarking is associated with higher outlays on roads than when there is no earmarking for this function. The fourth test, which relates to the degree of earmarking, verified the previous findings, since there is a positive cor- relation between earmarked revenue as a proportion of gross investment and highway expenditure as a proportion of gross investment. Both the cross section and the time series analysis confirmed this relationship. However, of these results, (i) and (ii) wiere tested and found not significant, whilst (iii) was significant for both cross section and time series analysis. In spite of tle lack of significance in (i) and (ii) our results lead us to believe that ear- marking contributes to a higher level of expenditures than in the absence of earmarking. The time series analysis adds particular strength to this conclusion.

122. Again with regard to those who put their entire faith into signifi- cance testing, three points can be made. It must be recognized that in this testing two main assumptions are those of normal distribution of the variable examined and of a random sample in relation to the population. Thirdly, the sample is large in relation to the population: 37 countries were examined which is nearly half the number of developing countries. There is no way of bringing the size of the sample in relation to the population to moderate or strengthen the conclusion. If another 30 countries could be examined, it is clear that a - h9 -

significance test would still have little relevance. These factors together with the uniformity in the five individual tests would justify the statement that "a relationship is suggested", between earmarked finance and a higher relative expenditure allocation for road works.

Explanation of findings

12'3. From the theoretical analysis in chapter IV and VI, it was shown that higher outlay on an economic function under earmarking than under general fund financing must be related to three factors:

i) Unstable majority coalitions which will not agree to tax- expenditure decision in the absence of earmarking.

ii) A correction of deviations in the legislated budgetary allocations. On the assumption that there is an elastic demand for the economic function for which there is a shift from general fund financing to earmarking there will be additional outlay on this function.

iii) With earmarking there is a reduction in unit costs through less waste and inefficiencies. When there is an alastic demand for road works, spending upon the earmarked function will increase as a result of the shift from general fund to earmarked finance.

124. To explain a larger public outlay on roads under earmarking, than under general fund financing is more complicated than first appears. This is because the mean proportion of earmarked taxes to road expenditure in our cross section was only 37 percent. In other words, for the earmarking countries an average of 63 percent of all road expenditures is financed out of the general fund and for this reason it is legitimate to question the relevance of earmarking.

A new theory of the budgetary process

J25. Until recently, very little systematic study of the determination of public expenditures had been undertaken. Government expenditure has typi- cally been taken as exogenously rather than endogenously determined in macro studies. Recently, however, in the U.S., a .theory ot the budgetary process has been developed, based on agency requests (through the Bureau of the Budget) and Congressional appropriations from 1947 through 1963, covering over half of the non-defense agencies- It has been found that fairly simple

1/ Otto A. Davis, M.A.H. Dempster and Aaron Wildawsly. "A theory of the budgetary process". The American Political Science Review. Sept. 1966. p. 529. I have benefited from discussing this theory with Dr. Charles J. Goetz. - 50 - linear equations can explain agency spending from year to year. The basic equations are: The agency request (through the Budget Bureau) for a certain year expressed as a fixed mean percentage of the Congressional appropriation for that agency for the previous year plus a random variable.1/ To illustrate the relevance of this budgetary theory to the earmarking case, let us look at Figure 4L.

Figure 4

Road expenditure

F1

.- , - -' F' 2 F'

'~~ ~ ~~~~~ - --. F..

G1 1 --- F 3--

fGge Xt~an,~ ~ ~ ~ ~ ~ ~~~F Go~~~~t fy t 2

T~~ime tl t2

1/Davis., Dempster, Wildawsky, Op. cit. p. 533. The main equations can be written in the generalized form

Xt = B Yt-1 + E where Xt = the appropriation requested by the Bureau of the Budget for ary given agency., for the year t.

Yt = the appropriation passed by Congress for any given agency or the agency request (through the Budget Bureau) for the year t.

E = a random variable (stochastic disturbance). - 51 -

126. Under general fund financing road expenditure over time develops along the trend line F9. The random disturbances around the trend are illus- trated by the curved line. Suppose now that a majority coalition agrees to accept a higher tax burden if the additional revenue raised is allocated to roads. This is our case of unstable majority coalitions. But we assume that additional tax revenue for roads (G1 - G) is raised contingent not merely upon the revenue being directed to roads in general but in fadt that it is destined to a region, to a specified class of roads, or to class of expenditures, such as for maintenance. In other words it is the earmarking of incremental funds that is crucial for determining the total expenditure on roads 'IOT the financing arrangements for the previous total of such expenditure. The assumption that earmarking is legislated not just for roads in general but for sub-sectors of this expenditure category, appears realistic. The stated purpose of the Ghana road fund, for instance, which existed from 1953 to the end of the 1950's is reported to have been to provide an accounting device to ensure that the full requirements for maintenance and repair were known and that sufficient resources were available to cover its costs.!/ The function of the-Kenya Road Fund was the same and the prevail- ing practice among French speaking countries in Hest Africa appears also to have been to earmark for the maintenance of roads and to use general fund financing together with external aid for the purpose of new construction.

127. What can the theory of budgetary behavior in the U.S. teach us in regard to the LDC's? The important lesson is that total expenditure rarely, if ever, is subject to review. "Instead this year's budget is based on last year's budge with special attention given to a narrow range of increases or decreases" 2/ Incremental calculations proceed from existing levels of expendi- ture. Among the participants in the budget making, there is a sharing of expectations, that programs will be carried out at close to the going levels of eicpenditure. There is now ample evidence for the fact that in complicated situations, such as budget policy making, hupan beings are likely to use heuristic rules or rules of thumb to enable them to find satisfactory solutions.3/ A priori there is no reason to believe that budgetary behavior in developing countries would follow more sophisticated rules. Hence, generally, existing levels of erpenditure wvould be more or less accepted in deciding upon appro- priations for the next year. Introducing earmarking into this model, we suggest that the earmarked revenue for financing incremental expenditure on roads does not negatively influence existing general fund allocation for roads. This assertion makes it possible for us to satisfactorily reconcile what our study suggests, namely, that earmarking is positively associated with a higher spending upon roads, despite the fact that earmarked revenue is only 37 per- cent of total road expenditure.

V/ E.K. Hawkins, Rbads and Road Transport in an Underdeveloped Country. A case study of Uganda. London HM4O 1962, p. 211. 2/ Davis, Denpster, Wlildawsky. Op. cit. p. 529

3/ Ibid. p. 543. 129. The second explanation for our suggested relationship arises since under general fund financing appropriations to be spent upon roads in general, may be partially dissipated. The reasoning is illustrated with the help of Figure 4. In period ti the additional revenue increases total road expenditure from Gd to Ga . In the absence of the accepted tax increase for roads, in line with the theory of budgetary behavior, spending upon roads would have continued to increases as before, along Fo, as a function of total agency spending in the previous period. In turn, at the Gl level, we assume that the rate of growth of road expenditure follows Fl, which is parallel to Fo. The new trend line be- comes Fg instead of F1 . There is nR wastage of earmarked revenue for which rea- son F2 has been drawn parallel to F2. The discontent among political groups in favor of road expenditurgs will increase as funds continue to be wasted and the gap between F1 and F2 increases. To correct for the budgetary deviatiOn, to return to the growth path Fl, the group (s) supporting road expenditures will push for a shift from existing general fund financing, to a higher proportion of earmarked finance. Earmarking contributes to a higher outlay on road works when the demand for road works is elastic with respect to tax price. If earmarking occurs in period t2, the trend line F) will be momentarily reached, before the dissipation of general fund revenue a.gain starts and the trend line becomes F3. The bureaucracy wfill of course tend so be discontent because a constraint in the form of earmarking will be imposed upon them in their budgeting.

130. Finally, in line with our theoretical exposition, the third explanatory factor is a reduction in unit cost. An accepted earmarking arrangement will re- duce the risk of discontinuity of investment in the sector concerned. This will encourage the development of entrepreneurial skills and improve long term plan- ning. There is evidence that at times it is entrepreneurial talent rather than capital or projects which is the real bottleneck to highway construction. The Iranian Road Study showed that, when funds are suddenly made available there may not be capable contractors to execute the works.l/ Evidence from Colombia and Ecuador support this finding.2/ When capable entrepreneurs have been the bottle- neck in highway construction, and earmarking of funds helps to remove this ob- stacle, road expenditure will increase. Another factor must also be taken into account.. It can be expected that improved long term planning will reduce con- struction unit costs. This factor may work either towards reducing or increasing total road expenditure, dependent upon the elasticity of demand for road works. If the demand is very elastic with respect to prices, both factors will generate a higher level of-road expenditure.

1/ IBRD Economic Report EC-147, September 26, 1966. An bconomic Reax=raisal of a Road Project, The First Iranian Road Loan of 1959. (IRN-222) 2/ In fact, a condition of the IBRD highway loan to Ecuador of 1964, provided for the setting up of a National Highway Eund, through which payments to contractors and suppliers would be channeled. It is reported that this arrangement has been helpful in supporting the contractor industry and improving the highway construction in Ecuador. Chapter VIII BENEFITS VERSUS COSTS OF ERIAMRKING

131. So far our analysis has centered upon the benefits of employing ear- marking. In a typical developing country, earmarking may:

(i) produce additional revenue because it is the equivalent of a contract between heterogeneous, unstable groups;

(ii) reduce unit costs of public spending;

(iii) correct deviations in budgetary allocations which may arise under general fund financing.

However the cost side of earmarking has not been discussed and it is upon the relationship of these to the benefits that a rational decision on the desirability of earmarking in any particular case must be made.

Budget Rigidity

132. We saw that the Lindahl model was a static model, which did not consider the time dimension. In some years, there may be excess supply of funds to the earmarked function, for which reason according to majority preferences, the excess funds should be allotted to other sectors, where the utility of increased spending would be higher. Because of the time dimension, it is to be expected that the benefits of earmarking would be dominant in the early period of the arrangement, while the costs - budget rigidity if it is found would be likely to arise only over: time. It follows that even if the costs are the same as the benefits for a given number of years, the present value of the benefits will exceed that of the costs, since the former will be bunched in the beginning of the period, whereas the latter are likely to take place towards the end. The higher the cost of capital (i.e., the discount rate) the more beneficial is the earmarking arrangement likely to be. An accounting evaluation is wrong in judging the benefits and costs of earmarking, just as it is Io1qny 9ther; economic decision involving time.

133. A distinction must be made between the case when there is some excess supply of earmarked funds, while the project is still in need of its full programmed support, and the case when the project is completed but the earmark- ing continues. The latter case will be a costly one if considerable revenue is locked up to the harm of other projects. Usually the government would avail itself of these funds through borrowing or transfers within the public sector. Ecuador is a good illustration of a country where earmarking has become very frequent to the extent that the coordination of budget accounts might have become a major obstacle. There has been a widespread earmarking to entities within the public sector, yet a mechanism for the transfer of excess funds appears to have worked well for a few years. For instance, between 1963 and 1966, when many of these agencies had large surplus funds, these surpluses were transferred for use elsewhere within the public sector through the use of so-called special guarantee bonds. These bonds were not used to shift resource from the private - 54 - to the public sector, but were instead an instrument to mop up surpluses to counter the widespread compartmentalizing of the public sector. Peru, another earmarking country, is an opposite case since the public entities have been unwilling to succumb to more central government control and invest their sur- pluses in government bonds. In the evert that swaps are not possible, it should be possible for the government to avail itself of the surplus funds in the form of non-inflationary borrowing from the banking sector. In this case, of course, there will be a cost attached to the borrowing. 134. No doubt the risk of budget inflexibility is likely to be higher, the larger is the number of specific earmarking arrangements. When there is a multitude of specific earmarking arrangements and when the earmarking arrange- ments form a large proportion of total government revenue, overall budget review and expenditure control very likely will suffer over time. This may oUt,: to be a compelling reason to limit the earmarking. In fact, groups who have benefited from earmarking because public outlays have been increased on public goods and services which they have favored, may realize that there is a point at which additional earmarking implies a cost rather than a benefit to them. Having established their favored expenditure in the budget, the need to continue the earmarking arrangement decreases particularly if, as previously noted, budgetary allocations are greatly influenced by previous budgetary allocations.

135. In developing countries, with very few exceptions, specific earmarked revenue does not represent more than 20 percent of total revenue. In Gabon, in 1963, 20 percent of total tax revenue was earmarked. In the Philippines in 1967, earmarked tax revenue was 11 percent of Central Government tax revenue. In Ice- land the proportion is presently 22 percent. It is worth remembering that remem- bering that in the U.S. in 1963, earmarked taxes as a percentage of total state tax collections, were not less than 41 percent; total earmarked taxes as a proportion of total federal and state tax collections amounted to 23 per- cent.l/ Among the LDC's, Brazil is an exception, where the ratio of transferred earmarked taxes to state governments and to function, to total budgetary tax col- lections of the central government was nearly 30 percent in 1965. This percentage would have been much higher, if the amount of taxes authorized to be earmarked, in fact had been transferred. Past defaults in transferring the legal amounts of earmarked revenue, and a reduction of overall earmarking in the 1967 Constitution may partly reflect the fact that legislation authorizing the earmarking of funds was not re-evaluated and changed in accordance with economic priorities. Ear- marked revenue as a proportion of total revenue became too large. What is impor- tant in the 1967 Constitution is that taxes can be excluded from being used for current expenditures and can be designated for investment expenditures. This pro- vision attests to the fact that in Brazil, in the final resort, earmarking has been considered an important instrument in promoting investment and curbing unnecessary current expenditures.

Periodic Re-evaluation of the Earmarking Arrangement

136. No fiscal institution should be permanent. Taxes just as well as tax concessions have a tendency to remain in force longer than needed. This applies to earmarking as well. In the U.S., a flagrant example of this is the continued presence in two states of taxes earmarked for Confederate war pensions.Z/ 1/ Earmarked State Taxes, Op. cit. p. 7. Total tax collections exclude social security ccntributions and trust funds. 2/ Ibid., p. 25. - 55 -

Particularly in the case of specific earmarking the rat-e of the earmarked tax should be changed regularly to bring it in line with actual revenue needs. In the case of U.S. highway special funds, the statutory allocations have at times been substantially higher than macro-economic considerations would have dictated. New Zealand, which has had a high degree of earmarking, is a similar case.; recently efforts have been made to reduce the funds assigned to the road sector. In 1965 it was announced that the National Roads Board, administering body for the road fund, considered its earmarked revenue from motor spirit taxation, license fees, etc, to be sufficient without the need for a contribution from the general budget./ In 1966, the earmarked revenues for roads were reduced. It was felt that the continued full implementation of the earmarking arrangements would lead to over-investment in highways. No doubt, a simultaneous situation of excess aggregate demand in the economy contributed to discussions whether the whole earmarking arrangements should not be scrapped in favor of overall general financing ~n order to avoid excessive inflationary pressures from uncontrollable expenditures. In Kenya,where there was a statutory earmark- ing of taxes for a road authority between 1951 and 1963, earmarking was dissolved under pressures arising from a tight budgetary situation. The explicit aim in setting up the road authority in 1951, was to attempt to isolate decisions on the maintenance and improvement of roads from direct political influences and to treat these matters as technical problems. The road authorityjanindepend- ent statutory body, was charged with maintaining and improving the road network. Its statutory revenue was composed of motor vehicle license fees, driving permit fees and approximately half of the petrol consumption tax. The authority wias responsible to the Minister for 'Works, the latter was also the executive agent for the work on the main road networlc. Subsidiary roads were maintained by means of grants to local authorities. The statutory revenues were, however, not sufficient to cover current expenditure on the roads. The deficit on the current account plus capital expenditures for nee construction works were covered by special appropriations. The relative independence of the road authority came to an end in 1962/63, in the circumstances of a tight budgetary situation. It was argued that because of the budgetary situation, the arrangements for meeting maintenance costs should be decided upon annually by the government, rather than by allocating receipts from specific taxes to the road fund.2/ The Kenya case illustrates the need for avoiding fluctuations in revenue for sectors, where long-range planning and continuity in maintenance are important, it may not be enough to institute an earmarking arrangement and a special authority. In the end the spending of the road authority was subordinated to wider can- derations. The Kenya.road fund has continued to exist but without statutory taxes.

1/ The National Roads Amendment Act 1958 provided for an annual transfer from Consolidated Revenue Account to the National Road Funds of not less than Ll million. Financial Statement 1965, New Zealand, p. 20.

2/ IBRD, The Economic Development of Kenya, Report of an Economic Survey Mission, 1962, p. 131. - 56 -

137. These three cases show that to avoid possible overspending and infla- tionary pressures, the earmarking arrangement should be reviewed at periodic intervals. Hospital construction in Peru is another case which illustrates the dilemma. In Peru, a tax on salaries and wages and revenue from various stamp taxes including an anti-tuberculosis tax and a share in taxes on the consumption of alcohol are directed to hospital construction. As a result, Peru has made important progress during the last few years in extending public health facili- ties and further reducing the incidence of communicable diseases. However, a scarcity of operating funds in the general budget and of health personnel has led to under-utilization of the new hospitals. Although perfectly balanced growth within and between sectors admittedly is difficult, the specific earmarking obviously has contributed to a budget rigidity. The cost of this rigidity should be contrasted with the benefit, that in the absence of earmark- ing there would in all probability have been much wlces investment in health.

138. When the provision of a link between tax and benefit was the only possibility to get a new tax accepted, it is not difficult to conceive of cases where a strong Minister of Finance or a bureaucracy may try to transfer this revenue to the general fund once it accrues. In Morocco, this has happened twice. Firstly a tax based upon the price differential between the import price of sugar and the domestic wholesale price was earmarked for irrigation develop- ment. The yield of this indirect tax has increased rapidly. In 1967, the revenue take was US$34 million and it is expected that this revenue will be largely in excess of what is needed for irrigation development. In view of this, it is not surprising that the Ministry of Finance has contended that a part of this revenue should be assigned to general current revenue. There was a precedent. In the aftermath of the Avgadir earthquake, a National Solidarity Tax for Agadir was instituted. Total receipts from 1960 to 1965 were substantial and amounted to DM 338 millions or the equivalent of US$ 77 million. Of this amount a mere third was allocated for reconstruction in the Agadir area, while the remainder was transferred to the general fund. From 1965 onwards, it was decided to transfer the total tax receipts from the National Solidary Tax for Agadir to the general budget.

1396 In all of the quoted cases the earmarking arrangements were successful since the objective of increasing expenditures on the earmarked function was met. In the absence of earmarking, the probability is that groups would have been entirely unwilling to agree to tax increases, and/or there would have been public spending for purposes which would not have accorded with the wishes of majorities in the legislative assembly. At any rate, public outlay on the earmarked functions is likely to have been significantly smaller. ilho. Examples of unsuccessful earmarking can also be found. In Argentina, it appears that earmarking of taxes for highway never really was accepted. In Argentina, a shortage of funds caused its present ten-year road program to be delayed by two years. It is reported that the major cause of the delay was a 50 percent shortfall in earmarked revenues in 1961 due to a new interpre- taion of the gasoline law; a further aggravation was the default of the revenue collecting agency in making full paynent of the highway authority's legitimate revenue. Subsequently, the devaluation of the peso resulted in price increases, which alnost doubled the peso cost of the program. Without a proportional - 57 -

increase in earmarked revenues and without additional funds out of the budget, the highway authority was unable to pay contractors on time, which weakened its position to make contractors comply strictly with specifications and completion dates. In 1965 extra budgetary increases in fuel taxes were pro- posed but never effected. A proportion of these tax receipts would have been allocated to the National Road Fund.

Statutory versus Constitutional Earmarking

141. Whatever the benefits of earmarking, the need to reevaluate its struc- ture over time cannot be overlooked. Ideally an earmarking arrangement should be introduced only with the provision that it be reevaluated periodically. Th facilitate such a revision, constitutional earmarking should be ruled out in favor of statutory earmarking. In the latter case tax laws can be easily amended, since a simple legislative majority is sufficient to effect a change in the tax law. In Brazil, 6amarkiagf -r UyA6aIne -too rigi&`prdctsely1 because it was embedded in the constitution. There is evidence that the critics of earmarking have focussed upon constitutional earmarking rather than statutory earmarking, subject to change by the legislature.!/ Honduras, for example, is an example of a country where constitutional earmarking is prohibit- ed.

Betterment Levies

142. Selective taxes such as the so-called betterment levies, charged upon those who benefit from public investment programs, are frequently earmarked to finance such investments. This kind of earmarked tax generally avoids the above criticism. It is close to a price for a service. Firstly, earmarking is usually statutory and not constitutional. Secondly, the levy is generally temporary and related to the cost of the public works to be undertaken. Fbr instance, farmers who benefit from an irrigation project are required to pay a betterment tax or irrigation levy.:. Equally, whenever road construction gives rise to increases in land values along the right of way, at least part of the additional land value may preferably be earmarked for road expenditure. Another type is found in West Africa; in certain areas forestry exploiting companies pay higher fuel taxes than elsewhere and the revenue is used to build forestry roads.

lI4. Already in 1953, a W4orld Ba k Study recommended special assessment financing in developing countries.i. "Special assessments will probably

1/ Earmarked State Taxes Op. cit., p. 26

2/ E.R. Schlesinger, "The Use of Special Assessments to Finance Development Projects," Economic Staff, IBRD 1953. - 58 - work best in the cases of high priority development projects which create substantial agricultural land improvement benefits and which are, at the same time, sufficiently large in size to warrant the added expense of making an adequate survey of apportionment of the levy." An example of an earmarked tax, a betterment tax i,hich has been very successful in financing urbanization is found in Colombia.L/ mis tax, the "impuesto de valorization" or valoriza- tion tax, is a capital gain tax, in that property holders in areas of rapid urbanization, where public investment in transportation, etc., is made, will pay a tax proportional to the betterment, or the ensuing increase in property value. The valorization tax recovers only the benefits from direct public investment, which enhances the value of the land. The valorization tax is payable either before the start of a project or at the taxpayer's option in installments over some two years. The tax is clearly a benefit tax. In fact, there is no sacrifice for the taxpayer since the value of his property will rise by at least the amount of the tax he must pay. "This is an important consideration where political resistence to paying taxes is high, as it is in most developing countries."12

144. In Medellin over the last twenty years, the present valorization tax has been fully developed in response to the need for financing public improvements in a fast growing industrial environment. In Medellin in recent years,the valorization tax has generated more revenue than the regular property tax, and has constituted not less than about 30 percent of the total current revenues of the city government. An impressive netwiork of parkways, limited access highways, improved river and canal works, parks, etc., have been financed with this revenue. There is also evidence that the valorization tax has not merely replaced other municipal taxes. Additional revenue has been forthcoming and no adverse effect on other taxes is reported.

145. In Bogota and Cali, the two-other large cities in Colombia, the valori- zation tax has as yet not worked as well as in Medellin where initially there was strong opposition to the valorizaticn. tax from large property owners. The latter finally had to abandon their hopes of profiting from public improvements financed out of taxes paid largely by other groups. In Cali, similar resistance from large property owners is still strong, for which reason the valorization tax so far has been less important as a revenue raiser. In Bogota, the perform- ance of the valorization tax has been better than in Cali, but it is not yet up to the standards set by Medellin. This is reported par-tly due to political interference in the valorization process. Yet, the valorization tax has brought forth about half as much revenue as the regular property tax. In Bogota the tax contributes about 25 percent of the city's total tax revenue.

116. The importance of the valorization tax and the revenue which can be raised through this tax stands out in Colombia because there are no organized capital markets where domestic funds can be borrowed for long enough periods at low interest rates to meet the heavy capital requirements of investment in urban infrastructure. Localcarrency costs of most "urban" investments are high. This accentuates the benefit of this earmarked tax since most external lending agencies are reluctant to finance investments which have.a high local cost component.

1/ Fbr description see William G. Rhoads and Richard A. Bird, "Financing Urbanization in Developing Countries by Benefit Taxation: Case Study of .Colombia"., LaidTEc-iomics, November 1967, p. 1 03. 2/ Rhoads, Bird, Op. cit. - 59 -

Earmarking for Maintenance or for Investment

147. Some argue that earmarking is justified in developing countries specifically for the maintenance of existing capital assets. If ineufficient expenditure is allocated to maintaining existing a6setsji the stock of these assets will rapidly deteriorate. Continuation of new investment will become uneconomic. There is ample evidence of the need for better maintenance in developing countries. Much concern has been expressed about the deterioration of physical assets through neglect of maintenance. In project loan negotiations, the World Bank usually requires assurances that there will be adequate maintenance of the capital assets, acquired through the loans. Ursula Hicks, amongst others, supports earmarking precisely because of the sore need of securing adequate maintenance and renewal of local fixed assets in developing countries. Since there is little possibility of borrowing for small projects, depreciation allowances must be accumulated from current budgets, which has proven difficult. It has been seen that earmarking for road maintenance is a common practice, not least among African countries. Hicks, although recognizing the rigi- dity argument against earmarking, considers "earmarking a lesser evil than the waste of resources and general frustration of constructing apparently wanted assets only to have them fall down again." 1/

148. On the other hand, in many countries earmarking takes place primarily for investment. Iran is a case and we have already noted that in Brazil earmarking is favored for investment, not for current expenditures. In fact, Hicks argued long ago that a policy of a stable rate of development will be assisted if a fixed charge for new investment is made on the current budget. This could be carried down directly to the development budget or to an independent development fund.2/ In the long run, it seems more worth- while to earmark for a development budget per s_, where a necessary shifting between current and capital and between different functions can take place without rigidity.

Earmarking for a Development Budget

149. Specific earmarking for individual economic functions such as roads, etc., is much more common than earmarking for a broad end use. How- ever in recent years there is evidence of a trend towards earmarking for a development budget or plan and away from specific earmarking. Behind this trend is the conviction in many LDC's that the continuing absorption of government revenue through increases in non-developmental expenditure must be curbed fcrceftU3yy in order to generate the desirable level of public savings. (See Chapter VI. paragraph 88 to 91 and 99 to 103). Besides the earmarking of oil revenues for the development plan in Iran which has already been discussed, this practice also occurs in Iraq. Recently an earmarking of oil revenue for the development

1/ U.K. Hicks, Development from Below, Oxford University Press, 1961, p. 429.

2/ U.K. Hicks, Public Finance, London, Cambridge University Press, 1947, p. 345. -60 - budget has been proposed for Indonesia; 25 percent of all these revenues would be earmarked to strengthen the development effort. The meagre Indonesian development budget in 1967/68 presently derived its only support from external aid. However, the regions benefit from a 10 percent export tax earmarked for development.

150. In Africa, there are other illustrations. In Gabon, where in 1962 20 percent of total tax revenue was earmarked, there has been a shift from specific earmarking for roads, forestry development, etc., to earmarking for the development budget as a whole. In 1963, the development budget was endorsed with separate domestic sources of revenue. The major part of the specific revenue allocated to the development budget was generated from a fixed share of the import turnover tax. This change in financing must be seen as a reaction of the Gabonese planners against the previous unsatisfac- tory situation, where the domestic financing of the development budget depended upon the size of surpluses on both the present and the previous recurrent budget. The development budget was exposed to the full fluc- tuations of government current revenue and current expenditure. Finally, in 1967, it was decided that 20 percent of total revenue, irrespective of origin, should be directed to the development budget. In the Democratic Republic of Congo, a similar earmarking started at the end of 1967; 10 per- cent of government revenue is earmarked for the development budget. The background to this decision must be seen against the fact that in the last few years, not less than 70 percent of ordinary expenditures have gone in the payment of wages and salaries.l/ It is certainly not surprising that development expenditures in this period hardly have exceeded 3 percent of total public outlays.

Program and Performance Budgeting and Earmarking

151. When there is earmarking for development the central budget office control of obligated and authorized spending is foregone. It is true that budget office control may have been synonymous with that spending authorized by the legislature takes place only partially or not at all. Although to employ earmarking in this situation is likely to increase spending upon the earmarked function, it is then desirable that there be some way of controlling how the earmarked revenue is spent. It is true that the auditing control remains. But the overriding consideration of the auditing procedure is usually financial accountability where emphasis is put mainly on the observance of appropriation limits. For this reason, it is essential that some way be found to inform the general public about the progress of the programs and projects which receive earmarked funds. It is crucial that earmarking does not become a "one time" institution. A continuing interest and support is necessary from the legislature and political groups. This support is fund- amental since various layers of the bureaucracy will consider earmarking as a constraint and an infringement on their administrative behavior. To

1/ The Government's payroll presently includes 60,000 permanent civil servants and an undetermined number of contractual civil servants, for whom estimates range from 100,000 to 300,000. - 61 - sustain the interest for development among population, for each year the progress on the schemes involved should be recorded for public consumption, together with original and revised estimates. This leads us to consider the possibilities of introducing program and performance budgeting in connection with an earmarking scheme.

152. The point of departure in our study was to estahlish the importance of earmarking, because it represents the mechanism through which public demand determines collective consumption. There are two parallels between earmarking and program and performance budgeting. Firstly, earmarking helps the public to weigh costs against benefits, i.e., taxes against expenditures. Demand for collective consumption is a function of the price of the public goods. Similarly the intention with performance and program budgeting is to introduce cost-benefit criteria into the budgetary procedure. A program and performance budget presents the purposes and objectives for which funds are requested, the costs of the programs proposed for achieving these ob- jectives and data measuring the accomplishments and work performed under each program.l/ However, a distinction should preferably be made between program and performance budgeting. The emphasis in program budgeting is on a budget classification, in which functions, programs and their subdivisions are established for each agency and these are related to actual and meaningful financial data. Performance budgeting on the other hand deals with more refined management tools, such as unit costs, work measurement and performance standards.

153. No doubt the total application of performance and program budgeting to supplement the administrative and legislative control of a broad earmarking scheme, assumes a fair amount of skilled and responsible manpower both for budget formulation and execution. There must be a close coordination between various governmental agencies and the planners and the central budget agency. But an anachronism arises, because most of these requirements run counter to the general conditions in the IDC's, which contribute to the importance of earmarking. To repeat, one of the major reasons to recommend earmarking arises because of the lack of sound budgetary operations and financial discipline. Therefore, although it seems preferable to concentrate a scarce supply of skilled resources to the execution of a development plan, instead of having the talent available widely distributed, it appears more realistic in the first instance, to expect that the simple approach or program budgeting be used. Meaningful performance standards may be developed over time.

154. The second parallel between earmarking and program and performance budgeting is the time aspect. Earmarking of funds promotes continuity in financing which facilitates long term planning. Similarly, program budgeting extends the time horizon, so that the future budgetary implications of programs adopted today are appreciated. For any plan to function and not to be a mere

1 Measuring Productivity of Federal Government Organization, Bureau of the. Budget - Washington - 1964. - 62 - document of good intent, it is necessary that the plan's targets are implemented through the annual budgets. In the real world the annual budget presentations commonly poorly reflect the target of the development plans. Earmarking gives the planners the assurances of continuity of finance, whereas program and performance budgeting indicates future recurrent cost of planned investments, which is essential for budgeting. Survey

155. Program budgeting is common particularly in South America.l/ At the level of Central Government, program budgeting is found in Argentina, Bolivia, Colombia, Paraguay, Peru and Venezuela. In Chile and Uruguay program budgeting exists, but it does not yet cover the entire central government. In most of these countries, program budgeting is spreading to public enterprises and independent public entities. Public enterprises have adopted program budgeting in Bolivia, Colombia, Ecuador, Paraguay, Uruguay and Venezuela. It is revealing that there is a relationship between countries having adopted program budgeting and those which prepare a capital budget, separating capital from current expenditures; thus Argentina, Chile, Colombia and Ecuador all have a separate capital budget. Outside of South America program budgeting is also found in Iran, Philippines, Taiwan and Thailand. In Africa, it is found in Egypt and Ghana.

156. It is possible to see a pattern among these countries which so far have adopted program budgeting. It is important to realize that those countries which have showed a strong preference for employing earmarking also have been the first to start using program budgeting. The countries in South America fall into this group. It is particularly important that a country like Ecuador has adopted program budgeting. The need for fiscal coordination of the numerous dependent and independent public entities in this country has already been referred to. Another clear case which illustrates the relationship between program budgeting and earmarking is the Philippines. In the Philippines, program and performance budgeting started already in 195h. Both the existence of program budgeting and earmarking must be seen as a projection of an environment where vested interests among the bureaucracy appear and where administrative inefficiency and political interference are common, thus making the need for fund control imperative. Earmarking and Short-run Demand Control Policy

157. The earmarking of revenue for a development plan as such, will not impose any restrictions upon changes in the composition of expenditures within the development budget. However, with regard to overall economic stability,

1/ Gonzalo Martner, Planificacion y Presupuesto por Programs, Siglo XXI Editores, S.A. Mexico 12, D F, 1967. remain allocated to the general fund, there should be considerable residual flexibility in the budget. With earmarking, there still should be a latitude left to manipulate taxes and expenditures in addition to other government policy variables.

159. In this regard, it is useful to return to the distinction between developed and developing countries. A report published by the Norwegian Ministry of Finance on the earmarking of taxes, took a negative view on earmarking. It was argued that earmarking would not work well under present financial and institutional conditions in Norway.1/ The principal objection was that earmarking would limit the possibilities of other direct and indirect instruments of an economic stabilization policy. It is true that earmarking might have an inbuilt inflationary bias. But this negative effect must be viewed in the perspective of the possible benefits arising from its use in a growth oriented economic policy. An earmarking of resources for development can help to reduce the anomaly, that when a deflationary economic policy is imposed, all too often the investment budget is completely jeopardized whilst non-developmental expenditures are left intact. Id the LDC's because financial and institutional conditions are entirely different from those in developed economies, it has been demonstrated that earmarking can be a very useful investment.

1/ The Nonregian Ministry of. Finance, Op. cit. CHAPTER IX

EARMARKING IN THE PHILIPPINES - A CASE STUDY Revenues

-i6o. A study of 37 developing countries, which ranks these according to pub- lic share in the national product shaws that the government sector in the Philip- pines is small. Philippines falls in the world's distinct class of low spenders together with Ethiopia, El Salvador, Guatemala, Honduras and Paraguay.l/ It is, of course, to be expected that tax collections also are low. In fact, the reve- nue performance in the Philippines has been dismal over a number of years, as seen against the dire need for increased public spending, particularly on infrastruc- ture. In 1966/67, total tax revenue as a percentage of GNP was 11.3 percent, which was an improvement by 1.2 percentage points over 1965/66, but just still below the 1963/64 tax effort. The following table shows the total of tax laws enacted from 1954 to 1967:

Type Number (1) Increase in Rates 5 (2) Decrease in Rates 4 (3) New Taxes Imposed 1 (4) Tax Exemptions 38 (5) Exemptions Withdrawn 3 (6) Others (including tax administration) 13

The majority of these measures appear to have reduced revenue rather than increased it. The total revenue loss from various tax exemption laws for the three fiscal years 1964/66 is estimated at Ps. 322 million, or an annual average of Ps. 107 million. There are strong indications that the tax effort in the Philippines would have been even less satisfactory in the absence of earmarking since this practice is quite common. In 1967, some 20 percent of Central Government revenue was earmarked to special funds. When the non-toc earnings of the Specid.l Funds are excluded, earmarked tax revenue as a proportional total tax revenue was 11 percent. The theory proved the importance of earmarking as a revenue raiser. There were three major reasons fcr this:

(i) Unstable political majority coalitions, (ii) Political interference in the budget execution, (iii) Administrative inefficiency.

1/ Joergen Lotz, Cp. cit., (Table 1). The public sector is measured by"'general government expenditure" which is defined to include expenditures of the cen- tral government, states and provinces, municipalities and cities. It also irncludes spending by agencies performing tax financed services, (most of these are the social security agencies.") The data are from 1963-65. (For compari- son, the five largestpublic spenders are Iraq, Algeria, Ghana and Malaysia). - 66 -

Unstable Majority Coalitions

161. The significance of earmarking in reaching an inter-3roup agreement about a tax-expenditure decision has been shown. Earmarking iS going to be more significant the more unstable are the possible majority coalitions in the political life of a country. In the Philippines there is evidence that the political life is fractionalistic. The executive has repeatedly been frustrated in securing the acceptance of tax programs because of the unstable majorities they rely upon. There is a lack of party discipline in the two main parties. Political aligaments are made largely upon the basis of personality rather than principle. There is comparatively little distinction on grounds of economic orientation or idealogy between the two political parties. Thus, party leader- ship is weakened, and when it comes to the enactment of the less palatable fea- tures of a legislative program such as new tax measures, they are generally de- feated, because of lack of support. Somewhat in contrast, the large number of tax exemptions in the Philippines reflect an asymmetry in that exemptions have been much more palatable to the legislature than new taxes. The frequency of tax exemptions agai point to the existence of a large number of groups striving to obtain public benefits. Political Interference

162. In addition to the lack of stable majority coalitions which prevents tax-expenditure decisions to be reached, there is secondly, political interfer- ence, and thirdly, administrative inefficiency and/or corruption. The existence of the latter factors reduces the taxpayers' willingness to adhere to existing tax laws and agree to new taxes. It is reported that there is a great amount of interference from pressure groups in the budget execution. "The budget execution phase of the budget process offers continuing challenge to the public administra- tors and managers of public resources on how well they can stand up to pressures from interest groups competing for budgetary support. It is difficult enough to decide or act even if the sole criterion were merely to minimize the risks of controversy with these groups. It is more so if one were to adhere closely to a rule of priorities so that only the most essential programs are given support from limited resources."l/ Earmarking acts as a shield in this situation, protecting priority allocations from political influence. Administrative Inefficiency

163. The third environmental factor conducive to the employment of earmark- ing has been the need to review the performance and fidelity of administrative officials. The need to review the performance of administrative officials was spelled out already by the Bell Mission in 1950, which initiated the setting up of a program and performance budgeting system in the Philippines. In the eyes of the public, earmarking helps to increase the administration's accountability in proving fund control, and thus it again increases the willingness to accept new taxes.

1/ Inter-regional workshop on Problems of Budget Classification and Management in Developing Countries (Copenhagen 1964). "Budgetary Developments in the Philippines since the early 1950ts - F. SyChangco, p. 27. - 67 -

Earmarking for Economic Development

164. We infer that the low tax effort would have been even lower in the absence of earmarking. In other words, the environmental or socio-economic conditions in the Philippines are very favorable to the use of earmarking as an instrument to increase revenue. Mgoreover, there appears also to have been a demonstrated awareness of the necessity to earmark available funds only for those areas deemed most vital from long term development needs.

165. In FY 1967, in the Philippines, total earmarked special funds revenue amounted to Ps. 430 million, which is 1/5 of total Central Government revenue. The total special funds revenue is composed of both taxes and non-tax earnings. The tax revenue amounted to 50 percent of total special fund income. The revenue in these funds can by law not be used for another purpose or be transferred to cover deficits in the General Fund. There is a multitude of these special funds, all in all they number 110. Many of these, however, are unimportant, and those which matter are:

F.Y. 1967 Amount Agency or Fund (million Ps.)

Highwray Special Fund, Republic Act No. 917/a 235.9 Portworks Fund, Bureau of Customs 50.1 Highway Special Fund Equipment Account 8.5 Securities Stabilization Fund 4.3 Manila International Airport Revolving Fund 8.8 Bureau of Printing Revolving Fund 7.5 University of the Philippines 10.0 Reparations Commission 8.9 Agricultural Fund, D.A. No. 85 5.6 Reforestation Administration 5.0 National Irrigation Systems, Act. 2152 4.8

/a Collecting agencies are Bureau of Public Highways, Customs, Internal Revenue and the Land Transportation Commission.

166. It is seen that the main emphasis is upon the transportation sector; highways, portworks and air transportation. In the fiscal year 1967, the income of the Highway Special Fund was not less than 55 percent of the total Special Funds revenue. Of the Highway Special Fund income, 73 percent was derived from tax revenue. Mlost of this (98%) comes from the excise tax on motor fuel.

167. If those budget expenditures which are classified as Economic Develop- ment and Social Development are analyzed, one finds that a major proportion of total expenditures on economic development is derived from the Special Funds. In 1966-67, this proportion was 37 percent of total expenditures on economic development. In contrast, social development expenditures, which comprise edu- cation, are mainly financed out of General Fund revenues. In 1966-67, only 7 - 68 - percent of these expenditures originated out of the Special Funds revenue. With- in the expenditures on' economic development, the Special Funds allocation were concentrated upon transportation and communication. Not less than 58 percent, or Ps. 238 million of total expenditures in this sub-sector were financed with Spe- cial Fund revenue. General Fund revenue accounted for 18 percent of the trans- portation and communication expenditure, whereas the Bond Fund wras used to finance the residual 24 percent. The Bond Fund is financed by public borrowings, and the proceeds are generally directed into investments.l/ It is noteworthy that the Special Funds revenue is designated for both current and capital purposes, includ- ing debt service.2/ In 1965, 69 and 67 percent of current and capital expenditures in transportation and communication, respectively, were Special Fund financed.

168. For the fiscal year 1967, it is possible to compare the planned targets for capital outlays wfith the estimated actuals-for the same year. It is signi- ficant that the only two expenditure categories, where actuals reached or ex- ceeded targets, wfere for highways and portworks. There is a substantial earmark- ing precisely to those two areas, and there is a reason to link this with the achievement of planned targets. In the same year, planned targets for overall investment, inclusive of transportation, was met only to 50 percent.

169. Even while earmarking undoubtedly has helped to mobilize revenue which otherwise would not have accrued for priority sectors of development, it cannot be claimed to be a complete success. What has caused dissatisfaction has been the accumulation of large unused cash balances in the Special Funds account, while the Government has been forced to display a considerable ingenuity in main- taining General Fund balances at an operational level and projects have been held up for lack of pesos. On the following page, the table shows the. cash balances of the General and Special Funds.

1/ There is a close similarity between bond financing for economic development and resource allocation for the same purpose through earmarking. Both the purchasers of bonds and those paying the earmarked tax are assured of the destination of the proceeds. The difference lies in the non-compulsory character of bonds, whereas a tax is compulsory and in that bond financing generally does not have the same degree of specificity with regard to end use as earmarking.

2/ Debt service has recently amounted to about 8 percent of total Special Fund expenditure. - 69 -

Current Account Cash Balances General and Special Funds - June 30, 1964-1967

(In millions of pesos)

1964 1965 1966 1967 General Funds 11 4 13 l43

Special Funds 151 205 320 360

Source: Bureau of the Treasury. The amount in the Special Funds as of June 30, 1967 was 8 4 percent of the total revenues of the Special Funds in that year.

170. In the Philippines, "surpluses" are shown in the budget as carried over from year to year. The surplus is defined as the excess of total receipts of the Government, inclusive of borrowxings, over total expenditures. The primary cause for these "surpluses" appears to be the unduly complicated formalistic and detailed nature of the disbursement formulas, which are established by law. How- ever, slowness in project execution per se might have contributed. For example, as of June 30, 1967 there wias a surplus of Ps. 210 million in the Highway Special Fund. The surplus roughly equaled the Bureau of Public Highways total-obligat- ed-expenditure accounts from Special Funds in the same year, and the same pic- ture prevailed for Portworks. With regard to the Highway Special Fund, there is a requirement that apportionments from this fund must be supplemented by local contributions before a project can be started. A lack of funds at the local level has been a major factor in the accumulation of undisbursed funds. This "holding" of obligated funds has meant that public borrowings have increased. To the extent that highwayconstruction is financed by borrowing from the non-govern- ment sector at commercial rates of interest whilst tViere are unused cash balances earmarked for this function, even though these funds may earn interest in the form of time and/or savings deposits, means an uneconomic use of public resources. If the "mechanics" function, funds should be transferred from projects with surplus balances to ensure their optimal utilization,-f4p- other projects within the highwayr sector and not be deposited with the private sector. - 70 -

The Highway Special Fund

171. It is not astonishing that there are disbursement difficulties, and that surpluses accumulate when one scrutinizes the statutes which regulate the disposition of all funds accruing to the Highway Special Fund. The manner of apportionment, and the conditions under which the apportionments are to be released are very formalistic. An elaborate set of percentages has to be calcula- ted to allocate accumulated funds between different maintenance and other expenditures and between provincial, city and municipal roads.

172. As to why the apportionment formulas are made so rigid, the explanation would simply lie in that all attempts have been made to eliminate fraud, corruption and political interference in the handling of the Highway Funds. Admittedly, in an environment where the importance and necessity of detailed regulations to facilitate fund control and auditing has a high priority, efficiency and flexibility in the handling of funds must suffer. The statutes of the Highway Special Fund do indeed attest to the concern over both administrative inefficieny and political interference in the administration of funds.

173. An example of the need to improve administrative efficiency is the regulation that administrative expenses must not exceed three percent of the revenue accruing to the Highway Special Fund. With respect to political interfer- ence, the statute is very outspoken. It is stipulated that no funds, whether from Government or from accumulated previous releases from the Highway Special Fund, shall be spent in a period of 45 days immediately preceding an election, except for maintenance works and certain other specified items. But even in the case of maintenance work, safeguards have been introduced to ward off excess spending for political purposes. 1/ Although it is clear from the above that an insulation of revenue, and a detailed regulation of the apportionment of this revenue is rational, the number of special funds and the dissatisfaction with the cash balances which accumulate has caused action to be taken. Thus, the President has appealed to the Congress to allow the transfer of the dormant special fund balances to the General Fund. A more radical step recently was taken at the level of local government. All special funds of local governments, except the Road and Bridge Funds and the Public Improvement Funds, have been abolished, and the revenue will accrue to the General Fund. At the local level, this would attest to the fact that it was felt that more budget flexibility was necessary, but that simultaneously earmarking for priority expenditure is considered a good thing.

1/ See Republic Act No.917, Sec.30: " Expenditures for purely maintenance works in existing roads, bridges ferries and other stream crossing facilities, the total disbursement of which shall not exceed the monthly average expenditure for such purposes in the province or city during the previous year; provided that the total monthly disbursement for all such provinces and cities shall not exceed Ps.3 million." - 71 -

New Tax Program

174. Our evaluation of the political and socio-economic characteristics of the Philippines suggests that in order to increase revenue, earmarking is probably essential. Our conclusion, suggested by the actual degree of earmarking, is further substantiated by the number of special fund arrangements proposed in the 1967-68 program. For earmarking, it was officially argued: "The creation of special funds or earmarking of certain taxes for special purposes is one of the good purposes of our fiscal system for two reasons. Firstly, special funding assures the service or provides a sustained and continuing source of financing, and secondly, it assures the taxpayers of the performance of the service for which they were paid.-I1/ It is finally emphasized that earmarking of funds is necessary if the development efforts are to be accelerated to meet the expanding needs of the rapidly increasing population. A nationwide survey on the tax consciousness is quoted in support for expanding the earmarking. This study disclosed that of some 1.9 million respondents, 87 percent expressed their willing- ness to pay a school tax, since they know that the end beneficiaries are the public schools.

175. Of the total additional tax revenue of about Ps.1 billion in the tax program, not less than 50 percent was proposed in the form of special funds. Of the nine proposed, two have been passed at the time of writing, namely, the Special Education and the Science and Technology Research and Development Fund. The approval of the former fund proved the correctness of the tax consciousness survey. The total annual expected revenue from these two funds is expected at about Ps.130 million, or some US$32 millions. The weight of the two special funds passed is evident, since they together account for half of all the new tax revenue, inclusive of tax administration measures. The tax base for the School and Special Education Fund consists of an additional real property tax whilst the Science and Technology Fund is fed by a tax on foreign travel and on privately owned vehicles.

Conclusion - Philippines

176. The tax consciousness in the Philippines leaves much to be desired when it is judged against the need for public investment, in particular for infrastructure. The reason for the lagging tax efforts are:

(i) A very individualistic society, where individuals are more important than party lines.

(ii) Political interference in the public administration.

(iii) Inefficiency and corruption in the public administration.

1/ Joint Legislative Tax Commission of the Philippines; " A Primer on the 1958 Tax Program," p.9. - 72 -

Total special funds amounted to one-fifth of Central Government revenue in 1966-67. If the non-tax earnings of the Special Funds are excluded, earmarked revenue as a percentage of total tax revenue was U percent. There is a reason to believe that in the absence of earmarking, most of this revenue would not have materialized. Earmarking has generally been directed to priority areas of economic development and is allocated for both current and capital purposes. Transportation has a high priority and it is significant that the only two investment fields where actual expenditure in FY 1967 reached or exceeded targets were highways and portworks, which benefit from a substantial earmarking. On the other hand, the disbursement formulas in particular for the earmarked highway funds, appear much too specific and formalistic, which might impede execution of the road works.

Re conmendation

177. New specific earmarking lqgislation ought to have a provision included that the tax laws should be re-evaluated periodically. Moreover, over time, there ought to be a transition from specific to less specific or broad areas of earmarking, such as for economic development per se. For instance, a develop- ment fund could be set up into which all the earmarking arrangements for high- ways, portworks, education, etc., could be amalgamated. The purpose obviously would be to continue to mobilize resources for development, which revenue other- wise would not be forthcoming, and to assure that this revenue is channeled into the development effort. And there would be no risk of distortions in the allocation between sectors. In fact, it might be said that such a beginning with earmarking for development has started with a recent imposition of a ceiling of Ps.2 billion upon the general fund current operating expenditure. In FY 1967, General Fund operating expenditure amounted to Ps.1,897 billion; the compounded annual growth rate, 1964-67 has been just below 7 percent. The employment of program and performance budgeting should be intensified to facilitate an evalua- tion of how the funds earmarked for development are spent. CHAPTER X

CCUCLUSIONS

"Living as we do, in the most possible of all wqorlds instead of the best possihlt one, we have too few policy instruments to rule out formal controls in advance."l/

Multiple preferences for public goods and services

178. This study has been a normative one. The purpose has been to analyze in what conditions earmarking of revenue is used and to deterinine its desirability. Can earmarking of revenue help in the development effort? Our answer is strongly in the affirmative. The theoretical exposition supported by empirical material, attest to the significance of earmarking in developing countries. The importance of earmarking lies not least in that it may increase developmental expenditures. Studies on the savings behavior if the LDC's lend support or at least do not re- ject the disturbing Please effect: tax increases are related with increases in non-developmental rather than developmental expenditures. More recently, Lotz with data on governmental spending in 37 developing countries finally confirmed the Please effect. (See Chapter VI). In fact, earmarking or formal controls upon revenue allocation in LDC's may be the only readily available policy instru- ment to change the basic conditions underlying the Please effect.

175. Our study is based upon the fact that in the real world multiple pre- ferencesexist. Typically, a number of political groupings is found, all of whom strive to maximize their benefits out of public expenditures. By comparison, if in our assumed universe, a single preference function would exist, there is no rationale whatsoever for earmarking. Uien there is a single preference function, there is merely one homogenous group and hence a uniform group will. The imposi- tion-of a control instrument in the allocation of tax revenue becomes unnecessary and inimical to the attainment of an optimum level and pattern of public expendi- ture.

180. Earmarking has been analyzed within the framework of budget policy. The simplistic analytical approach to study either taxes and their incidence, or ex- penditures and their allocation, without examining the link betwreen them has been avoided. Instead, the point of departure has been the welfare economics approach to government. This theory is based upon the view "that the economic role of government is to facilitate an optimum allocation of resources in the total econo- my. "a/

181. Our analysis has followed the Lindahl theory. This theory deals with the analogy between the budget determination in the public sector and the price formation in the market for private goods and services. In a two group, two public

1/ Irving H. Siegel, "Guidelines for the Perplexed," Journal of Economics Issues, Vol. I, Number I and II, June 1967, p. 16. 2/ Richard A. i4usgrave (1959), Op.cit. - 7L - good model, it has been proved that a simultaneous considerat:'an of taxes with expenditures is necessary to ensure Pareto-optimality (see Chj..ter II with Annex ). Thus, when an additional public expenditure is introduced, the expenditure alloca- tion (the benefit) must be decided simultaneously with the dist'ibution of the tax burden (the cost) between groups. This led to the conclusi m that a special assigning of revenue, a specialization of the budget, may become necessary. Theory versus a model parliamentary democracy

182. The nature of political decision-making becomes crucial when the Lindahl theory is compared with the actual conditions of a model parliamentary democracy. Through majority voting, the coercive power of the representative political groups must be used to compel tax contributions from the voters and to allocate expendi- tures through the instrument of government bureaucracy. A number of divergencies arise when decision-making under majority voting in a model parliamentary democracy is compared with the Lindahl model. Two most important of these divergencies for our analysis are:

(i) Voting and legislative procedures which do not produce a simul- taneous consideration of taxes with expenditures. (ii) Large number of groups.

183. Firstly, there is generally a separation in time and attention between the basic legislation of taxes with that on appropriations. This is the case in the U.S., in the U.K., and it appears in most other countries. TWhilst an implicit and not explicit statutory assigning of revenue might have been possible had the legislative procedures assured the joint consideration of taxes with the distribu- tion of the tax burden, in this situation to assure this joint consideration a legal binding of tax revenue to the corresponding expenditures becomes crucial. Secondly, whilst the Lindahl model only deals with two groups, in the real world there is typically a large number of groups. Cooperative solutions to preference revelation become harder to reach between groups. The likelihood of a "stalemate" and no tax-expenditure decision increases. A majority rule budgetary model demon- strated that earmarking becomes even more important in this setting in producing a cooperative solution with net benefits for a majority coalition (see Annex to Chapter II). Earmarking substitutes for a lack of confidence between political groups.

184. IWhat would happen if a joint consideration of tax with expenditure and an enforcement of the solution reached does not occur? In the absence of a joint consideration of taxes with expenditures the fiscal optimum would not be reached. The tax price (the cost) would become equated with the marginal benefit of addi- tional public outlay only by coincidence. In the case of a parliamentary democracy, at the end of the legislative period, for a majority coalition the tax price (cost) of additional public expenditures would be likely to be lower than the marginal benefit these expenditures would yield. A disequilibrium and an underprovision of public goods and services would arise.l/ Because of the lack of both a joint con- sideration and an enforcement of tax and eypenditure, a tax-e.xpenditure solution with net benefits for a majority coalition will not be agreed upon. On the other hand, if the assumption of public preference determination through a functioning parliamentary democracy is dismissed, there may be over, as well as under pro- vision of public goods. One group -- for instance, the military -- may impose its will upon a majority and force this majority to carry a higher tax burden than it desires. For this majority, the tax price of additional public expendi- ture becomes higher than the benefit of this expenditure.

185. Finally, the comparison of the Lindahl model with a parliamentary demo- cracy pointed to the fact that besides earmarking there are additional means to offset the divergences between the Lindahl model and a model parliamen-tary demo- cracy,,namely program and performance budgeting, and local government or the decen- tralization of government policy making. The objectives of earmarking, decentra- lization of governmental policy making, and program and performance budgeting are similar. A cost-benefit analysis of taxes paid is facilitated by all of them. These three instruments can all be seen as reflections of a pluralistic political, social and economic environment, of multiple preferences for the use of public funds. It is instructive that both the U.S. and Switzerland, federally adminis- tered countries, have a relative high degree of earmarking. It is equally instruc- tive that in many countries where there is a sizeable degree of earmarking, program and performance budgeting also exist. The Philippines and many countries in Latin America are examples.

Theory versus developing countries

186. Fundamental to the analysis of this paper is to emphasize that when comparison of the LDC's with the Lindahl model is made, the divergences between this model and a typical parliamentary democracy become magnified. The two fac- tors wihich contribute to increasing disparity between the model and the conditions in a developing country are:

(A) Inefficiency in reaching a tax-expenditure decision at the legislative level;

(B) Inefficiency in the administrative allocation of funds.

187. To start with, in the environment of most LDC's perfect cooperation be- tween groups becomes an even less plausible assumption. This follows because of the widespread lack of social cohesion and trust between groups. Typically, there will be a plurality of interests for functional as well as for regional purposes. There will be unstable majority coalitions in the legislature and accommodation between groups about the distribution of tax burdens and the corresponding expen- ditures (the benefits) becomes more difficult. (See Chapter II) The probability of arriving at an optimum tax-expenditure agreement is further reduced. In com- parison with a model parliamentary democracy, the optimal level of public

1/ See J. K. Galbraith, The Affluent Society, London 1958. Leif Johansen, (1965), Op. cit., p. 124. J.G. Head, Op. cit., p. h48. - 76 -

expenditure is even less likely to be reached in developing countries. The importance of earmarking in these circumstances is clearly revealed. In the absence of enforcement with regard to end use of the additional tax revenue to be raised, groups wiho accept to pay a share of the tax burden will have no assurance that another majority coalition does not appropriate the tax proceeeds for its ow*m purposes. Earmarking assures the contract between political groups to enforce the tax-expenditure decision. Group interests will be accommodated and if no group is made worse off, Pareto-optimality will be achieved.

188. In contrast to inefficiency at the political level, where the problem is how to raise additional tax revenue, the study has also been concerned with the importance of earmarking for reducing inefficiencies in the allocation of existing tax revenue. Two factors were considered:

(i) Earmarking puts a constraint upon the bureaucracy and corrects deviations in the optimal spending pattern, and

(ii) Earmarking reduces unit costs in public spending.

189. Hence, there is a second reason why in developing countries the will- ingness to pay taxes is low and why the fiscal optimum will be hard to reach. It is most likely that not only another legislative majority may decide to use tax revenues for purposes, in conflict with those agreed to by those groups carrying the whole or part of the tax burden. The bureaucracy may as well cause an unopti- mal expenditure allocation. The bureaucracy is not a neutral disinterested agent in executing public expenditures. Political pressures upon the bureaucracy, vested interests and corruption within the administration exist, and contribute to in- crease the probability that tax proceeds are diverted to purposes in conflict with the true interest of taxpayers. These factors will introduce deviations in the budgetary allocations decided upon by the legislature. Moreover, it was emphasized that these deviations are likely to favor non-developmental over developmental expenditures.

190. There is a considerable bias against developmental expenditures under general fund financing. With few exceptions, non-developmental expenditures, particularly those of a transfer nature have a priority over developmental spend- ing. This bias is readily apparent in periods of deflationary economic policy, wihen investment budgets often are severly curtailed, whilst other public expendi- tures may remain entirely intact. To correct this situation, the discretionary power of the bureaucracy should be limited. Earmarking limits the discretion in the budgeting and allocation of funds. With a two public good model, it was assumed that there will be a return to equilibrium, to the budgetary allocation endorsed by the legislature through the use of earmarking. Deviations in the allocation of funds wfhich arise in the budgeting and disbursements of funds will be corrected. Earmarking may, therefore, increase developmental expenditures. A simple game theoretic model showed that not merely the "community" but even the bureaucracy in the final resort would stand to gain by the imposition of formal controls (see previous discussion in Chapter VI). - 77 -

191. With regard to the second factor, earmarking by producing assurances of finance, is likely to reduce unit costs in spending on the function receiving ear- marked revenue. For example, unit costs in road construction may decrease because continuity in finance would promote long-term planning and attract capable contrac- tors. This would operate to reduce unit costs of road construction. For a given amount of revenue, a larger quantity of public goods and services would bepurchased.. Taxpayers satisfaction will increase.

Displacement effect

192. Earmarking ensures the necessary simultaneousness consideration and linking of tax and expenditure proposals. It contributes to the attainment of a higher satisfaction of group wants and thus pareto-optimality. Earmarking raises additional revenue, for which reason spending on the earmarked 2tnction will be high- er than in the absence of earmarking. This effect of earmarking is analogous to the Peacock-Wiseman displacement effect.l/ These authors showed from the data for the U.K. that public expenditures increase stepwise over time. There is no smooth continuous trend over time. In countries which are not exposed to extra- ordinary pressure or events, a certain conception will form as to reasonable or acceptable levels of taxation. As long as these opinions prevail, there will be increases in public expenditure, pari passu with increases in general income. Also, there is usually a great deal of inertia, which by itself limits the possi- bilities of reaching new tax expenditure decisions. A considerable increase in public expenditure, as a share of national products will only arise if a shock occurs. "In settled times, notions about taxation are likely to be more influen- tial, than ideas about desirable increases in expenditure, size and rate of growth of the public sector."2/ In other words, in times when public expenditure is stagnant in relation to national product, there may be tensions between the needs for public expenditure and the limits set by taxation on what can be effected in the way of expenditure. Should a shock then occur in the form of a war, as in the case of U.K., social upheaval or economic crisis, the customary notions about the acceptable taxation level flinch and a new level will be reached. And this level will remain until the next shock occurs, etc.

193. The "catalyctic" effect of earmarking in raising more revenue has been amply demonstrated throughout the study. For instance, in Morocco, in the after- math of the Agadir earthquake a National Solidarity Tax was instituted, earmarked for the reconstruction of Agadir. In the Agadir case, the displacement effect of the catastrophe, in combination with an earmarking of'this revenue produced the necessary political consensus to impose the new tax. An impressive amount of revenue wfas raised. (See Chapter VIII).

Empirical findings

194. The theoretical analysis of the study would have remained somewhat sterile, had there been no attempts to test the theory with data from develop- ing countries. By itself, the frequency of earmarking and the situations in which

/ Alan Peacock and Jack Wiseman, "The growth of public expenditure in the United Kingdom." The NLtional Bureau of -conoinic Research, Princeton, 1961. 2/ Peacock and Wiseman, Op. cit. - 78 -

it occurs attest to the importance of earmarking in certain circumstances. Speci- fically, however, evidence from a large number of countries, e.g., Brazil, Colombia,'the Democratic Republic of Congo, Ecuador, Gabon, Iran, Morocco, Peru and the Philippines, as well as the cross section and time series analysis under- taken of highway expenditures for some 40 countries indicate that earmarking is associated with a higher relative expenditure allocation to the earmarked function, than when there is no earmarking. (See Chapters VII and VIII).

195., The highway data revealed a somewhat puzzling feature namely that although the average proportion of earmarked finance to total expenditure on the earmarked function was merely 37 percent, yet a positive relationship appeared between earmarking and a higher relative expenditure allocation to the earmarked function. This fact was seen to be less incongruous if the recent knowledge about the nature of the budgetary process in the U.S. is applied to the develop- ing countries. The "new theory" indicates that expenditure allocation takes place primarily on an increinental basis year to year. The previous year's spending is taken as given when current year's appropriations are decided. (See Chapter VII). Therefore, when earmarking occurs, expenditures are likely to be pushed up to a higher level, which will not be retrieved. It should be readily apparent that if this theory is applied in particular to the LDC's, it is wrong to infer that earmarking is of mere nominal value if earmarked funds are supplemented by general fund finance. Earmarking is likely to have raised the absolute level of spending upon the earmarked function. M4oreover, we found that the earmarked funds within a broad expenditure category, often are assigned to specific, functional purposes. In the case of roads, earmarking for road maintenance has been a frequent practice.

196. The finding that existing expenditure levels are generally accepted and that annual expenditure allocations takes place on an incremental basis is a central issue. The "new theory" of budgetary process is strengthened in that not merelytheirMU.S.data support this thesis. Both the Peacock-WViseman research and the "displacement effect" and the findings of Pryor enhance the validity of this theory. (See page 63 ). To explain this acceptance of existing levels of expenditure, one must infer that among a majority there is a consensus about the desirability of maintaining public expenditure pari passu with increases in general income. Elsewhere it ha stated: "Politics"been -- rightly -- is primarily concerned with new programs. "_ Th put it differently, in the case of road expenditure, at least a majority coalition is supporting the existing composition and volume of road expenditures. One main reason for this support would be that this public good has important externality features. In other words, the benefits accrue to the public at large and not just to one single group which has a narrow functional or regional interest.

197. However, asswne there is a group interested in a particular type of road expenditure, class of roads or a regional road network. The desired outlay will be of "group good character," of direct and immediate benefit to this individual group. In a democratic context, the group in favor of this group good,

1/ Peter F. Drucher, The Age of Discontinuity Harper and Row, New York, 1969. "The politician's attention does not go to the 90 percent of money and effort that is devoted to existing programs. They are left to their own devices and to the tender mercies of mediocrity." - 79 - equity considerations aside, will have to shoulder a higher tax burden the fewer are the externalities of this specific good. Previously, it has been demonstrated that this group might want to pay this price, only if it obtains assurances through earmarking that their tax payments in fact will be of direct benefit to them. For instance, highway users agree to be charged for using the facili- ties by paying an earmarked tax, e.g., a tax on gasoline.

Developed versus developing countries

198. Formal controls in revenue allocation are much less frequent in develop- ed than in developing countries. In developed countries, the benefits of earmark- ing are generally less than the costs arising from the budget rigidity which may develop over time. The benefits of earmarking are higher in developing coun- tries because of the particular environment of those countries. In fact, the difference in environment between these two groups of countries can also explain the little success of income taxes in developing countries. (See Chapter I). For an income tax to work, there must be a minimum of social cohesion, political morality, administrative competence and respect for the government. In the absence of these conditions, taxpayers compliance with existing taxes and willing- ness to pay additional taxes is going to be low or even non-existent. Moreover, they have little or no guarantee for total public spending will take place in accordance with their own priorities. The large degree of earmarking throughout Latin America can be explained because of the fact that the above conditions are generally not satisfied. Richard Goode pointedly put it: "Until the popular will is stronger and more united or until the rich are ready to accept the ability- to-pay-principle wihether from altruism or b sense of guilt or fear -- steeply progressive taxes will not be collected. I4I Precisely, because of the existence of pluralistic societies with a modicum of social cohesion, formal controls over revenue allocation will continue to be necessary. In this context, it should be recognized that just as earmarking at the national level is a reflection of conflicting group interest in the use of public funds, so at the international level the tying of the assistance to projects and sectors is a reflection of a similar lack of confidence between nations even when acting through an inter- national agency. (See Chapter V.)

Reevaluation of earmarking

199. The benefits of earnarking in the particular circumstances of many developing countries are clear, but our support is not unqualified. Earmarking may have a cost attached to it in the form of budget rigidity, which will, in particular, develop over time. Even while, of course, in the absence of earmark- ing no additional revenue may have come forth and hence no problem of budget rigidity would arise, the cost of budget rigidity must not be neglected. In the study we have pointed to cases where earmarking has been very rigid, but as a consequence it has been partially circumvented. Brazil is such a case. Fbr this reason, earmarking shoild in general be statutory and not constitutional. . A simple legislative majority should be able to revise the legislation. Second- ly, in the earmarking legislation, it should be possible to stipulate that the arrangement be subject to periodic reviews.

1/ Richard Goode, "Reconstruction of Fbreign Tax Systems," Op. cit., p. 171 ANNEX I ANNEX I Page 1 DECISION MAKING IN A PARLIAMNTARY DEMOCRACY - MAJORIrY VOTING

1. In order to express the value judgments about what is the "best" distribu- tion of taxes and public expenditure, it was necessary to establish the required conditions for Pareto-optimality. In this search the "simultaneousness" condition became pivotal in the t"determination" of public expenditure. But even under a simultaneous consideration of public expenditures and taxes, the voting procedure may not give us an optimal solution. Pareto-optimality cannot be guaranteed under majority voting. Yet, in all those cases where the majority votes for a spending- tax solution which makes a section of the community better off without causing any loss to the other members of the community, the conditions for Pareto-optimality are satisfied. It is easily understood that this may not always be the case, a majority ruling may incur a cost to the minority. Nonetheless, we consider that Pareto-optimality is possible by majority decision.

2. Let us briefly consider some of the possible methods of passing from individual or group taste to collective will, from rationality and welfare aspects. The instrumentaj4ty of majority voting is best understood by considering the Arrow voting paradox.-1 This is the classic example of the inability of getting a majori- ty to decide on what is best, if the preferences of the voters are inconsistent.

3. Assume that we have three persons or groups A, B, and C, who are about to vote. They favor three alternatives a, b, and c respectively. The preferences of the three persons are expressed:

A a) b) c B b c a C c) a) b

The outcome, if all the three alternatives are voted upon simultaneously, is that none will be accepted. Each alternative will obtain one vote. We now turn to the case where the votes are given simultaneously on two alternatives. When a and b are voted upon we find that persons A and C will vote for a, whilst B, of course, will vote for b; a is accepted by the majority. But when a and c are voted upon, the opposite is true. The majority rejects a and decides upon c. Finally when alternatives b and c are voted upon b wins. Thus:

a> b c>a b>c

The dictum of the majority vote is disconcerting: a is better than b but worse than c, whereas b is better than a. We would have expected that a would have been preferred over c, which is normally the case where an individual rationally ranks alternatives. The "anomaly" in our case stems from that the majority does not comprise the same persons in the three votes. j/ K.J. Arrow, Social Choice and Individual Values, Wiley & Sons, Second Edition, New York, 1963, p.124. ANNEX I Page 2 4. When the voting procedure takes place in a sequence, the outcome will depend upon the order of the sequence. What matters is which is the alternative first to be voted upon by the three persons. In the illustrated case, there are three possibilities:

1st Round Result 2nd Round Winner a -b a) b a -c c a -c c> a c-b b b -c b > c b -a a

It is revealing that the result of the voting is unpredictable, as long as the voting sequence is undetermined.

5. Is this case a realistic one for determining the public expenditure? Sup- pose that we rank the preferences of the three persons along a scale where one al- ternative is the favored one and the other alternatives are less preferable the further away they are situated from the best alternative. Consider, a, b, and c as large, medium and small. Person A prefers large over medium, and medium over small. Person B prefers medium over small, but when the choice is between "small" and "large", he elects "small". Individual C is an odd case. He prefers "small" over "large", but if "small" is not accepted he votes for large. Let individual C become more rational. He would then prefer "small" over "medium" and "medium" over "large". The preferences become:

Person A a> b> c Person B b c > a Person C c> b> a 6. Now a vote taken on two alternatives at a time produces the following situation: b> a, c) a, b> c, which is not contradictory like the above one. The result is interesting; any voting on two alternatives produces b, or "medium" as the favored solution. The same result is obtained irrespective of which alterna- tive is the first one to be voted upon. But the solution is not that straightfor- ward if the votes are cast only upon one alternative at a time. Had we started by considering the b or medium alternative, Person A would have voted against, since b is too "small", whilst c is opposed to b, because it is too large. And in the second count alternative c would have been accepted, since Person B prefers c over a. On the other hand, if we start with the extreme alternatives a or c, either of the extreme alternatives will be rejected on the first count and b will be preferred in the second count. Thus, in this voting procedure, a condition for arriving at an unequivocal result is that the voting starts with the extreme alternatives. 7. Let us return to the voting for public expenditure and the way to distri- bute the burden of expenditure between groups. Whenever it is possible to rank the alternatives along an axis from "best to worse", we should be able to choose be- tween Pareto-optimality points without encountering ary of the previous difficul- ties. We have seen that the majority voting in a system where the alternatives are ANNEX I Page 3 ordered by rank may be a satisfactory system. This will not always be the case. lWhenever the voters' preferences on utilities between consecutive alternatives in the ranking differs widely, the solution obtained is not satisfactory. In other words, when the utility function is discontinuous and not continuous, majority voting does not assure a Pareto-optimal solution. There are various ways to over- come this difficulty, by types of wxeighted voting, which we will not enter into. Most if not all of these schemes however, do appear to be too complicated for the real world situation.S/

1/ For a further discussion see Richard A. Musgrave, Op. cit., 1959, Chapter VI. AMNEX II ANNEX I Page 1

EARMARKING FOR HIGHWIAYS IN DEVELOPING COUNTRIES

Statistical tests

1. Simple regression analysis

The regression equation for the 18 earmarking countries is:

R = a + b T where R = Road expenditure, I = Gross investment and T = Earmarked Taxes. We obtain R = 4.8 + 1.5 T. The correlation coefficient is 0.7 and is significantly I I different from zero at a level of significance of one percent.

2. Multiple regression analysis

When GNP/capita is added as a second independent variable our equation becomes R = a + b T + cZ; where Z = GNP/capita; we obtain the following equation

for all the eighteen earmarking countries. (Figures within brackets express sampling errors of regression coefficients).

R = 5.2 + 1.5 T - 0.22Z; where Z = GNP/capita expressed in T I hundreds of US$

(0.3) (0.25) 2 The coefficient of determination Ro is 0.50. The multiple correlation co- efficient is significantly different from zero at a level of significance of 1 percent. The partial correlation coefficient of road expenditure/GDI regressed on GNP/capita is 0.0. It is seen that GNP per capita does not help in explaining more of the variation in the dependent variable.

3. If New Zealand is excluded, our regression equation becomes:

R = 4.3 + 1.6 T + 0.09Z 2 IT.50 'AO = (0-4) (0.95)

The multiple correlation coefficient is significantly different from zero at a level of significance of 1 percent.

4. If Madagascar is excluded we obtain:

R = 7.0 + 0.6 T + O.OlZ 2 I I Ro = 0.01 (o.4) (0.23)

The multiple correlation coefficient is not significantly different from zero at a level of significance of 5 percent. ANNEX II Page 2

5. Time series analysis

Analogously to the cross section analysis above, road expenditure/GDI Kenya, was regressed upon earmarked taxes/GDI and GNP/capita for Brazil, Ethiopia, New Zealand and Peru. GNP/capita was measured in domestic currency at constant level prices. The earmarked taxes/GDI variable is significant at the 1 percent for all countries but Peru, in explaining the variation in the dependent variable. Our second independent variable GNP/capita is not significant at the 5 percent level for any of the five countries. From this we conclude that the relevant equation is the simple regression R = a + T. I I

6. Analysis with dummy variables

An additional multiple regression analysis was made to determine the ex- time planatory value of GNP/capita. To increase the number of observations, the varia- series for the individual countries were grouped together by using dummy 1 for bles. For each of our five countries, the dummy variable has the value of the number of observations, otherwise it is 0. In a generalized form our equa- tion becomes:

R = a + b T + cZ + dl xi + d2 X2 + *-* d5 x5 I I

GNP/capita was measured in US$ constant prices at 1964 prices at 1964 exchange rates. Again GNP/capita turned out as a non-significant variable in explining The variations in R, while T is strongly significant at the 1 percent level.;V I I- dummy variables were all non-significant. We conclude that in our sub-sample, alloca- there are no inter-country characteristics which do explain the relative tion of funds to the road sector.

7. Spurious correlation

In principle our results may be biased because of spurious correlation, gross since both hightTay expenditures and earmarked taxes have been divided by domestic investment. This eventuality was not considered very likely at the rela- time of writing. But to convince ourselves, a further test was made. The for tive variability of GDI, road expenditure and earmarked taxes was calculated a rela- five countries Brazil, Kenya, Madagascar, New Zealand and Peru. We obtain tive index of variability through dividing the standard deviation of the time the series by the mean for the respective series. This allowed us to compare and relative variability for each country of GDI versus that of road expenditure earmarked taxes. Of these five countries, only one, Peru, displayed a larger In other variability of GDI, than of both road expenditure and earmarked taxes. substan- words for only 10 out of a total of 47 observations, might we suspect a satis- tial degree of spurious correlation. This evidence should be sufficient to of spur- fy us, that there are no significant distortions in our results because ious correlation.

bias. 1/ The test for serial correlation at the 5 perc(nt level reveals no such BIBLIOGRAPHY

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