Fiscal capacity is the ability of the state to extract revenues to provide public goods and carry out other functions of the state, given an administrative, fiscal accounting structure. In economics and political science, fiscal capacity may be referred to as tax capacity, extractive capacity or the power to tax, as taxes are a main source of public revenues. Nonetheless, though tax revenue is essential to fiscal capacity, taxes may not be the government's only source of revenue. Other sources of revenue include foreign aid and natural resources.
In addition to the amount of public revenue the state extracts, fiscal capacity is the state's investment in "state structures—including monitoring, administration, and compliance through such things as training tax inspectors and running the revenue service efficiently". When investment in these administrative or bureaucratic fiscal structures are specific to the state's power to extract resources, fiscal capacity is moreover related to a larger concept of state capacity. Finally, given that public goods funded by fiscal capacity include infrastructure development, health, education, military and social insurance, a state's fiscal capacity is essential to its economic growth, development, and state-building.
Definitions and patterns Fiscal capacity is the ability of the government to raise revenues, and is frequently measured as the proportion of gross domestic product generated by tax revenue. Overall, wealthier developed countries have larger, stronger tax administrations and raise more money through tax revenue than poorer, developing countries. As is such, the more revenue a government collects, the greater fiscal capacity is. However, fiscal capacity is measured not only by the level of tax revenue a state is able to raise, but by the tax administration's ability to enforce tax policies.
Besley and Persson (2012) present a list of "stylized facts" that describe the evolution and patterns of fiscal capacity. These facts are patterns identified from an analysis of cross-sectional and time series data on 73 countries since 1800: Rich countries have made successive investments in their fiscal capacities over time. Rich countries collect a much larger share of their income in taxes than do poor countries. Rich countries rely to a much larger extent on income taxes as opposed to trade taxes than do poor countries High-tax countries rely to a much larger extent on income taxes as opposed to trade taxes than do low tax countries. Rich countries collect much higher tax revenue than poor countries despite comparable statutory rates.
Tax structure Fiscal capacity changes from state to state, not only in the amount of tax revenue that each state is able to extract but also the way in which revenue is extracted. Specifically, different types of taxes are considered more economically efficient, and accordingly more ideal, than others. More information can be found on tax types and economic efficiency in the page on Tax. The strength of a state's fiscal capacity is thus determined by not only the amount of revenue collected, but also influenced by the efficiency of its tax structure.
For instance, optimal taxation theory states that the ideal tax structure maximizes efficiency; inefficient taxes include the corporate income tax, tariffs and seignorage, while efficient taxes include income taxes and consumption taxes such as the value-added tax. As is such, richer developed countries and states with strong fiscal capacity tend to rely on these efficient tax types, whereas the opposite holds true for poorer, developing countries.
Poorer countries tend to rely on less efficient tax types, and accordingly have weaker fiscal capacities. Likewise, developing countries with weak fiscal capacities are more likely to be unable to provide public goods. The social science literature on fiscal capacity and economic development aims, in part, to solve this puzzle of why developing countries cannot strengthen fiscal capacity by simply increasing their use of efficient tax types and lowering the use of inefficient tax types.
Low fiscal capacity is typically a consequence of underdeveloped political, social and economic conditions in a state. First, as countries differ in their investments on the military, public education, infrastructure (etc.), different tax structures can reflect varying preferences for private versus public goods, and redistribution. Secondly, inefficient tax structure and weak fiscal capacity indicate the presence of tax evasion, a relationship that is further examined in the section below on the informal economy. Overall, favorable tax types are correlated to greater fiscal capacity because they impose fewer economic efficiency costs, but also encourage more efficient tax collection by minimizing tax evasion.
In practice
Informal economy When fiscal capacity is weak, governments are not able to monitor or tax the entire population. The informal economy is the part of the economy that is not monitored by the government. It exists when the general population can easily evade taxes due to factors such as low tax-morale, low-quality governance, and insufficient resources for large, quality tax administrations like that of the US's Internal Revenue Service. Likewise, informal economies have a larger presence in developing countries. In 2000, Friedrich Schneider and Dominik Enste estimated that the size of "the informal economy on average is only about 15% of GDP among OECD countries... However, among developing states, the median size of the informal economy they report is 37% of GDP, ranging from 13% of GDP in Hong Kong and Singapore to 71% in Thailand and 76% in Nigeria." Informal economies also explain why developing countries cannot simply raise tax rates, like in their more developed counterparts, to attain a higher GDP or fund more public goods.
When taxes are raised, people have an incentive to shift out of the taxable formal sector into the non-taxed informal sector so as to avoid paying higher tax rates. States with regions culturally unaccustomed to the idea of tax collection have low tax morale, and are even more likely to circumvent the state's attempt to impose taxes. Thus, compliance depends on the social and political environment of the state, as well as the ability of administrations to enforce compliance. In poorer states with low administrative capacities, the presence of large informal economies may mean that it is easy for people to avoid taxes if tax are raised.
As a solution to tax evasion, governments with lower administrative and technological capabilities place less efficient but more easily monitored taxes. For instance, it is difficult to track the incomes for each individual within the population in order to collect income taxes, or the sales of each good and service to collect consumption taxes. Comparatively, it is much easier to impose an import/export tax at specific checkpoints along the border. Tariffs are easier to collect because they require fewer technological or administrative resources, and do not necessarily require depend on a strong cultural of tax compliance. Additionally, Emran and Stiglitz (2005) argue that adding "tariffs may provide a less distorting source of tax revenue" because it may encourage tax evasion less than for instance, increasing income taxes. In other words, if certain types of taxes incentivize the general population to move into an informal economy out of the control of the government, it may be in the government's best interest to exact tax types that will discourage tax evasion in spite of economic efficiencies. Thus, despite the superior efficiency of certain tax types compared to others, taxes traditionally considered inefficient may better achieve fiscal goals in the presence of informal economies.
All in all, states with low fiscal capacity tend to use inefficient tax types when large informal economies are present, and if they do not have the administrative capacity to support the collection of efficient taxes.
Economic models of tax evasion Besley and Persson have developed several economic models to better understand non-compliance, and why developing countries are not able increase their fiscal capacity by simply raising taxes. Focusing on taxes on income and consumption, Besley and Persson's (2012) general model demonstrates that citizens always have the incentive to evade taxes, and they will only choose not to evade if the cost of evasion (i.e. a tax penalty) is too high. This cost depends on the government's ability to monitor individuals and sales and enforce penalties, an administrative capability that requires a history of investment decisions to improve the tax administration. In other words, whether or not citizens choose to participate in the informal economy today depends strongly on the conditions and choices made by policymakers of the past. If citizens are more likely to participate in the informal economy, than the state cannot improve fiscal capacity by simply raising taxes if it does not have a political, legal and fiscal history that has supported such state-power.
In comparison to Besley and Persson's individual level study, Gordon and Li (2009) focus on the role of businesses and the financial sector in developed versus developing countries. They model businesses' participation in the financial sector—where Gordon and Li specifically refer to participation in the financial sector as using banks—as participation in the formal sector; they assume that tax authorities can monitor bank records, so that mass participation in the financial sector lends the state information and likewise, the power to tax. Gordon and Li (2009) demonstrate that because the financial sector is important in developed countries, businesses will choose to use banks and not evade taxes. Comparatively, the financial sector may be weaker in developing countries and businesses may have less incentive to use the banking system and instead opt to use cash. As is such, Gordon and Li (2009) conclude that "as the financial sector improves in effectiveness, more firms will be pulled into using it in spite of the tax implications of doing so".
Administration Fiscal capacity and tax structure depends immensely on the strength and capabilities of the tax administration itself. However, tax administrations are complex and require a vast amount of resources that not all states can afford. In "Administrative Dimensions of Tax Reform", Richard Bird explains that the strength of a tax administration is determined by the number of trained personnel, adequate infrastructure (including technology and modern computer systems), as well as a functioning "information system". This information system determines which goods and activities are to be taxed (the tax base), as well as identifies, classifies and monitors taxpayers. It further facilitates the collection of information from each individual, third parties, and other sources from within the tax administration. In addition, there should also exist a system of rewards and penalties to enforce tax compliance. And finally, there must be a system to both redress grievances and complaints should the system fail, and identify and address mistakes with the tax system before they occur.