Preliminary draft- FUNDACIO D'ECONOMIA ANALITICA Fiscal Capacity and State Fragility Timothy Besley LSE and CIFAR Hannes Mueller IAE (CSIC), MOVE and Barcelona GSE November 28, 2019 Abstract This chapter discusses issues that arise in building an effective fiscal state and relates this to debates about causes and consequences of state fragility. It argues that the lack of capacity to raise revenue is symptomatic of a wider range of issues that lie at the heart of state fragility including a weak private sector, a lack of legitimacy and poorly functioning administrative structures. Building the capacity to mobilize revenues requires building a social contract based on a culture of voluntary compliance in addition to strengthening more tangible aspects of the state. This has far-reaching consequences policies that aim to strengthen fiscal capacity in the context of fragility. We thank the participants of the workshop on Macroeconomic Policy in Fragile States in Oxford in December 2018 for useful feedback on this project and on an earlier draft. We also thank Lavinia Piemontese and Sacha Dray for excellent research assistance and comments. All errors are ours. 1 "It is shortage of resources, and not inadequate incentives, which limits the pace of economic development. Indeed the importance of public revenue from the point of view of accelerated economic development could hardly be exaggerated." Nicholas Kaldor, ‘Taxation for Economic Development," Jour- nal of Modern African Studies, 1963. "[T]he fiscal history of a people is above all an essential part of its general history. An enormous influence on the fate of nations emanates from the economic bleeding which the needs of the state necessitates, and from the use to which the results are put." Schumpeter, The Crisis of the Tax State, 1918. 1 Introduction While there are many dimensions to state fragility, a weak capacity of the state to raise revenue is a key feature. Technical support is often provided to increase revenue generation as, for example, when a country reforms its VAT system. And international organizations like the IMF as well as donors play a key role in assisting with these more technical aspects of revenue mobilization. But raising taxes is not only a technical issue but a political and social one. Low tax revenue not only reflects the tax system or a weak economy but also an incompetent and corrupt bureaucracy, lack of cohesiveness in the operation of the state and a weak civic culture in the population. Studying revenue goes well beyond the narrower concerns that, without tax revenues, the state cannot support its citizens. It lies at the heart of the compact between a state and its citizens. The task of raising fiscal capacity in this context therefore needs to pay attention to these dimensions to succeed. The capacity to mobilize revenues can come from three main sources. First, the economy has to be conducive to levying taxes. Hence having a larger formal economy with large firms will generally make compliance easier. Second, there needs to be investments in monitoring and compliance that makes it feasible to collect taxes owed. Third, citizens have to be willing (at least to some degree) to comply with the demands of the tax system. Relying exclusively on monitoring and compliance is costly. Even though the tax share tends to increase with income, it is well-known that countries raise different levels of revenue per capita even controlling for GDP. 2 Unlike low levels of revenue mobilization, fragility is hard to define and measure. This is because fragility is essentially a statement about risks, i.e. the risk of failure when put under stress. But failure is not easy to define in the context of the multi-dimensional responsibilities of states and measuring the risk of failure is therefore complicated. Commonly used approaches, in- cluding the CPIA used in this volume, harness aggregates (typically weighted sums) of many indicators to capture fragility. This has the advantage of giving the measurement a broad base but the disadvantage of being less transparent and generating the tendency to evaluate fragility ex-post. For example, a country will tend to be labelled as fragile after it has experienced the outbreak of armed conflict in its territory or a dramatic decline of its GDP.1 Here we follow IGC (2018) which argues that there are six key symptoms of fragility in general: (i) Weak state capacity: a failure to invest in fiscal, legal, regulatory and spending capabilities of government. (ii) A weak private sector: economies are characterized by a large informal sector with few large firms and poor legal structures in place which hampers taxation, (iii) Lack of Security: the state is not able to provide security from disruptive actors (such as organized criminals or militias) throughout its territory. (iv) Weak resilience: the economy often relies on few sectors and is subject to external shocks which threaten political stability. (v) Low levels of state legitimacy: society suffers from low levels of trust and reciprocal compliance; and (vi) Polarized societies: prevalence of oppositional identities whether ideological, ethnic, linguistic or religious. Different polities display these symptoms to differing degrees. Moreover, countries that have functioned effectively for long periods of time may occasionally display some of these symptoms. The symptoms of state fragility are best thought of as lying on a contin- uum with multiple dimensions. Underlying causes are more complex still. Many of the dimensions reinforce each other and there is no clear-cut causal structure. While it is important to keep the wider picture in mind, it can be useful to examine a specific aspect of state effectiveness as we will do here. By unpacking issues around revenue mobilization, we will gain wider insights 1 For a discussion of the CPIA and its relationship with future risks see Celiku and Kraay (2017). In their recent report, the OECD (2018) tried to avoid this problem and instead framed fragility as a combination of risks and coping capacities through a principal component analysis of over 40 variables. However, fragility even in this dataset should be regarded as much an evaluation of realized failures (a fall in the growth rate) as a measure of unrealized risks. 3 into fragility problems and the specific challenges that need to be addressed to create a more effective state. Taking this to heart, this chapter looks at the challenge of building fiscal capacity and discusses how it is related to contemporary concerns about state fragility. It will argue that these two lines of thinking have strong commonalities and that by learning about one specific weakness in the way that the state works —poor revenue raising capacity —we learn a lot about how states function effectively in general. Therefore, a key message developed here is that it is essential to move beyond purely technocratic approaches to revenue mobilization and to incorporate an appreciation of the political and social dimensions of fiscal capacity. The chapter is organized as follows. The next section reviews some important background elements. It discusses some of the relevant ideas in the literature on the role of institutions, civic culture and state capacity. In section three, we look at some evidence drawn mainly from correlations which we use to build a narrative and argue that increasing fiscal capacity is related to the development of the state, society and the economy. Section four discusses some policy conclusions and suggests that a new conceptual approach is needed for international engagement on problems of low fiscal capacity and state fragility. We suggest that much greater attention has to be paid to political economy issues. 2 Institutions, Norms and Culture Underlining the importance of political institutions has now become an es- tablished line of argument in explorations of the factors that are conducive to economic development. Seminal historical work by North (1990) and North and Weingast (1989) envisages building institutions that restrain the state as the sine qua non of economic development. A recent literature in political economy such as North et al. (2009), Acemoglu and Robinson (2012) and Besley and Persson (2011) stresses the role of building political institutions which create greater cohesiveness as lying at the heart of state effectiveness. There is now a large body of supporting evidence (see Acemoglu et al. 2005) that institutions affect the path of economic development. One key issue is how far institutions are codified into rules and formal structures. Mapping these has certainly provided valuable insights into cor- relates of state performance. Less easy to measure are the more informal 4 aspects of institution building such as how far people choose to behave co- operatively within a set of rules which relates to norms and beliefs about how an institution will work. Increasing attention has been paid to this (Acemoglu and Robinson, 2018, and Bisin and Verdier, 2017) and it leads to a greater interest in the role of culture in making states function effectively. This links to an older literature in political science which gives a key role to transformations in civic culture in explaining how governments work (see, for example, Almond and Verba, 1963, and Lipset, 1960). A good illustration of the importance of civic-culture is the study of diplomatic parking tickets by Fisman and Miguel (2007). Diplomats to the UN in New York come from different countries but face the same institu- tional environment in New York. Until 2002, diplomatic immunity protected UN diplomats from parking enforcement actions. Fisman and Miguel show that diplomats from countries with high levels of corruption (on the basis of survey-based indicators) accumulated significantly more unpaid parking violations. And the effect is large with diplomats from the most corrupt countries accumulating about 80 percent more parking tickets than diplo- mats from the least corrupt countries.