Public Finance for Poverty Reduction

This volume is a product of the staff of the International Bank for Reconstruction and Development The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.

Public Finance for Poverty Reduction

Concepts and Case Studies from

Africa and Latin America

Blanca Moreno-Dodson and Quentin Wodon,

Editors

Poverty

Public Finance

for Poverty Reduction

Concepts and Case Studies from Africa and Latin America

or acceptance of such boundaries.

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ISBN: 978-0-8213-6826-8

eISBN: 978-0-8213-6827-5

DOI: 10.1596/978-0-8213-6826-8

Library of Congress Cataloging-in-Publication Data

Public finance for poverty reduction : concepts and case studies from Africa and Latin America / edited by Quentin Wodon, Blanca Moreno-Dodson.

p cm.

Includes bibliographical references and index.

ISBN 978-0-8213-6826-8 ISBN 978-0-8213-6827-5 (electronic)

1 Finance, Public Developing countries 2 Poverty Government policy Africa Case studies.

3 Poverty Government policy Latin America Case studies 4 Africa Social policy Case studies.

5 Latin America Social policy Case studies I Wodon, Quentin II Moreno-Dodson, Blanca HJ1620.P826 2007

Cover design by Quantum Think, Inc.

Cover photo by Richard Lord.

Richard Musgrave

The Father of Modern Public Finance

(1910–2007)

Professor Musgrave was convinced that governments have

an important economic role to play, and that taxes and public expenditures can be used to improve social welfare

He served as a senior adviser to many governments, especially in Latin America and Asia One of the editors of this book [B Moreno-Dodson] was privileged to meet him at the International Institute of Public Finance Congress and to benefit from his wisdom on critical

public finance issues

His legacy will endure

Blanca Moreno-Dodson and Quentin Wodon

Rationale for the Role of Government 2

Limits to Government Intervention in 4

Developing Countries

The Way Forward: Topics for Future Study 14

vii

Part One Concepts in Public Finance: Debt, Taxation, 19

Public Expenditure Tracking Surveys, and Benefit

Incidence Analysis

Chapter 2 Debt Sustainability for Low-Income Countries: 21

A Review of Standard and Alternative Concepts

Danny Cassimon, Blanca Moreno-Dodson, and

Quentin Wodon

Traditional Approaches to Debt Sustainability: 24

A Brief ReviewOperationalizing Debt Sustainability Concepts: 36

The HIPC InitiativeAlternative Approaches to Analyzing Debt 40

Relative Use of Different Tax Instruments 71

Effectiveness of Tax Instruments in Redistributing 77

Wealth or IncomeEffectiveness of Particular Tax Provisions 80

in Reducing the Tax Burden on Poor People

Chapter 4 Assessing Front-line Service Delivery: Public 89

Expenditure Tracking Surveys

Ritva Reinikka and Jakob Svensson

Provider Surveys: Key Features and Potential Uses 91

Survey Applications in Selected Countries 95

Role and Adverse Consequences of Asymmetric 102

Information in Public Spending

Conclusion 105

Chapter 5 The Impact of Budgets on the Poor: Tax and 113

Expenditure Benefit Incidence Analysis

Jorge Martinez-Vazquez

Estimating the Incidence of Public Expenditures 135

Net Fiscal Incidence: Combining Tax and 147

Expenditure Incidence

Part Two Case Studies from the Latin America and 163

the Caribbean Region

Chapter 6 Analyzing Debt Sustainability: An Application 165

of SimSIP Debt for Paraguay

Bernhard G Gunter and Quentin Wodon

Alternative Approaches to Analyzing Debt 169

SustainabilityTheoretical Foundations for the Modules in 171

SimSIP DebtSimulations for the Debt Projection Module 175

in ParaguaySimulations for the Deficit-Debt Consistency 181

Revenue Adequacy: Comparing across Countries 189

and Examining the Budget Deficit

Buoyancy of Revenues 195

Excess Burdens and Economic Distortions 199

Weak Tax Administration and High Tax Evasion 216

A Potential Tax Reform Package: Feasibility, 218

Content, and Revenue EffectsAnnex: Estimating Marginal Effective Tax Rates 222

on Investment

Chapter 8 Measuring Targeting Performance through Public 233

Expenditure Tracking Surveys: Peru

José R López-Cálix, Lorena Alcázar, and

Erik Wachtenheim

Central Government Targeting of Social Spending 234

Funding Transfers from Central to Local 242

Government: Efficiency Problems

Recommendations for Social Safety Net Programs 299

Annex: Estimating the Incidence of Social 303

Protection Programs

Part Three Case Studies from Africa 309

Chapter 10 Analyzing Debt Sustainability: Concepts and 311

Tools Applied for Guinea, Rwanda, and Senegal

Bernhard G Gunter and Quentin Wodon

Review of Previous and Current Debt Relief 312

InitiativesDebt Accumulation, Stagnation, and Debt Relief 317

Using Debt Projections to Analyze Debt 322

SustainabilityUsing SimSIP Debt’s Deficit-Debt Consistency 333

Module

Chapter 11 Analyzing the Potential Impact of Indirect Tax 345

Reforms on Poverty with Limited Data: Niger

Saloua Sehili and Quentin Wodon

Medium-Term Targets for Public Revenues and 349

Structure of TaxationAssessing the Impact of Indirect Tax Reforms: 353

VAT ExemptionsComparison of the Incidence of Taxation to the 362

Incidence of Social Spending

Budget Processes: Flows of Funds in the Health 380

and Education SectorsTracking the Flow of Funds in the Health Sector 384

Tracking the Flow of Funds and Its Impact in 391

the Education Sector

Key Findings and Policy Implications 396

Chapter 13 Assessing the Targeting Performance of Social 417

Programs: Cape Verde

Diego Angel-Urdinola and Quentin Wodon

Incidence of Public Transfers and Targeting 419

PerformanceFactors That Determine Targeting Performance 423

Improving Targeting Performance 428

9.1 Interagency Collaboration in Beneficiary Identification 289

and Delivery of Benefits

9.2 Appropriate Evaluations Can Improve Program Impact 291

and Efficiency: The Case of the PAE

9.3 Institutional and Budget Autonomy Producing Success: 293

ProJoven

9.4 How to Fail in Targeting the Poor When There Is a 296

Good Example: The Case of PNCA–P and PNCA–M

Figures

6.1 Initial Conditions and Basic Macroeconomic Assumptions 176

6.2 Results of Different Export Growth Scenarios 177

6.4 Results of the Baseline, Pessimistic, and Optimistic 179

Scenarios

6.5 Results of Different Revenue and Expenditure Scenarios 180

8.1 Lorenz Curves in Selected Social Programs 237

8.2 Lorenz Curves for Health Care Expenditures 238

8.3 Lorenz Curves for Education Expenditures 239

8.5 Lorenz Curves for Intergovernmental Transfers 244

10.1 Total External Debt, by Decades, 1970–2000 318

10.2 Total External Debt, Annually, 1990–2001 318

10.3 Total External Debt as a Share of Government 319

Revenues, 1990–2001

10.4 Total External Debt as Share of Exports, 1990–2001 319

10.5 Exports of Goods and Services, 1990–2001 323

10.6 Annual Growth Rates in Exports of Goods and 323

Services, 1990–2001

10.7 Exports and Annual Growth Rates in Exports, Rwanda, 324

1990–2001

10.8 Grants Provided to the Government Budget, 1990–2001 324

10.9 Grants as a Share of Nongrant Government Revenues, 325

Guinea and Senegal, 1990–2001

10.10 Grants as a Share of Nongrant Government Revenues, 325

Rwanda, 1990–2001

10.11 Initial Conditions and Baseline Macroeconomic 327

Assumptions

10.12 Assumptions on Public Domestic Debt 328

10.13 Results of the Baseline, Pessimistic, and Optimistic 330

Scenarios, 2001–16

11.1 Incidence of VAT Reforms Compared with Social 363

3.2 Comparative Composition of Tax Revenue, Selected 74

Years, 1985–97

4.1 Leakage of Public Funds for Education, Uganda, 1991–95 96

6.1 Short- and Long-Term Consistency Matrices 181

6A.1 Trends in Paraguay’s Debt, 1991–2000 185

7.1 Marginal Effective Corporate Tax Rates on Domestic 201

Capital Investment

7.2 Tax Burden by Income Decile: Baseline Scenario 210

7.3 Tax Burden by Income Decile: Alternate Scenario 211

7.4 Distribution of Net Income among Income Deciles 213

7.5 Distribution of Gross Income among Deciles: Base 214

8.3 Targeting of Individual Beneficiaries by Food Assistance, 240

Health Care, and Education Programs, 2000

8.4 Per Capita Transfers to Municipalities, 2001 245

8.5 Municipalities That Did Not Know the Transfer Arrival 247

Dates

8.6 Municipalities Subject to Central Government 248

Supervision, 2002

8.7 Percent of Transfers Used for Current Expenditure, 2002 249

8.8 Leakage for FONCOMUN and Canon Minero Transfers 251

8.9 Beneficiary Households That Received Training/ 256

Information on “Milk” Preparation and Allocation, 2002

8.10 VDL Presence of Significant Transfer Delays 257

8.11 Leakage at Transfer Stage 3, from Municipality to 259

Local Committees

8.12 Leakage at Transfer Stage 4, Household Level 262

8.13 Leakage at Transfer Stage 5, Beneficiary Household Level 263

8.14 VDL Leakage at Various Transfer Stages 265

9.1 Scope of Social Protection Programs, 1999 276

9.3 Social Protection Coverage and Costs, 1998 281

9.4 Social Protection Incidence and Expenditures, 1998 282

9.5 Social Risk Coverage and Deficiencies 287

10.2 Committed Debt Relief under the Enhanced HIPC 321

11.3 Aggregate Statistics on Consumption Categories 354

Targeted for Indirect Taxation

11.4 Consumption Shares of Comparable Goods by 357

Income Decile, 1995 and 2004 Surveys

11.5 Incidence Analysis for Proposed Tax Reforms, Niamey, 359

2004 Survey

11.6 Benefit Incidence Analysis for Selected Categories of 364

Public Spending, Niger, 2000

12.1 Sampling Distribution of Health Facilities and 378

Population across Administrative Regions, 1998–99

12.2 Sampling Distribution of Educational Facilities and 378

School-Age Population across Provinces

12.3 Distribution of Education and Health Care Facilities 381

and Resources across Administrative Regions, 1998–99

12.4 Funds Transferred to Regional Health Offices, 1999 386

12.5 Transfers of Operational Expenses to the District 387

12.8 Exemptions from Paying School Fees and Number of 397

Children Not Admitted to the First Year of Primary

School Because of Classroom Overcrowding, 1999/2000

12A.2 Key Findings and Recommendations for the Health Sector 404

12A.3 Key Findings and Recommendations for the Education 406

Sector

12A.4 Summary of Problems and Solutions Proposed by 408

Regional Health and Provincial Education Officers

12A.5 Problems and Solutions Identified at District Health 409

and Education Offices

12A.6 Problems and Solutions Identified at Health Centers 410

and Primary Schools

13.1 Decomposition of Determinants of Public Transfers 426

Performance

13.2 Errors of Exclusion and Inclusion in a Proxy Means- 430

Testing Model

13.4 Means-testing Performance under Different Poverty Lines 433

13.5 Geographic Targeting Using Census Data 435

13.6 Geographical Targeting Versus Proxy Means Testing 436

Public Finance for Poverty Reduction provides an innovative analysis of

many difficult policy issues plaguing less-developed economies in ing their economies while achieving poverty reduction It is well worth aread It is, in part, a good application of the framework developed by the

grow-late Richard Musgrave, who defined public finance as a field of study

con-cerned with the government’s functions focused on resource allocation,distribution, and stabilization of an economy It also is appropriately con-cerned with administrative practice, and it provides excellent case studies

on some new approaches to improving fiscal, spending, and tax policies

in less-developed economies

Resource allocation is critical to understanding how public policies fect both the static and the dynamic efficiency of an economy or, in otherwords, the best allocation of resources to achieve the highest standard ofliving Distribution is concerned with the support given to the peoplewho are the least well-off in society, while ensuring that policies are ap-plied equally to those who are similarly well-off Fiscal stabilization, lessinvoked these days with the importance of monetary policy targeted atinflation, is still critical to policy in a world where deficits and debt canproduce havoc in a government’s ability to raise capital from internation-

af-xvii

al markets and to afford program spending without having to increasetaxes to fund it.

Although each of these public sector functions is well defined, offs are always involved in reaching each Redistribution of resourcesthrough tax policy or spending programs can have incentive effects thatundermine economic efficiency if people decide to work, save, or investless in markets Efficient tax policies—a head tax being one of them—could impose heavy burdens on the poor Tight fiscal policies to avoiddeficits and foreign indebtedness can make it difficult to implement pub-lic programs that are needed to improve the economy or support the poor.Life is never simple for governments, especially those in less-developedeconomies where the trade-offs frequently are more difficult to achievewith limited resources Moreover, the outcomes can be stark, with highlevels of poverty if successful results are not forthcoming

trade-Although often it is easy to identify good reasons for public tion by governments, it is another matter to witness good implementa-tion of public programs—so much so that some people argue that governments should consider a hands-off approach rather than starting

interven-up ill-designed programs Thus, it is critical to understand the tive resources available to governments to implement policy as well as theincentives for governments to carry out public policies to achieve worth-while public objectives without being corrupted by poor practices.The advantage of this book is that it is not restricted to the typical ap-proach used in public finance texts: outlining theoretical ideas and someeconometric knowledge for helping with the application of the ideas In-stead, it provides interesting new approaches to implementing growth-oriented and poverty-reducing spending, tax, and fiscal stabilization poli-cies that have been attempted in various countries

administra-The first chapters in Public Finance are appropriately “theoretical” in

re-viewing basic concepts, such as fiscal sustainability, revenue design, countability measures, and tax and benefit analysis Without focusing toomuch on the concepts alone, the chapters provide good discussions ofpractical solutions to some of the difficulties faced by governments inreaching their objectives

ac-The chapters in Part Two evaluate approaches to policies to stabilizethe economy, reduce poverty, or implement better spending programs inParaguay, Mexico, Peru, and Uruguay Part Three focuses on the poorestcontinent—Africa—with case studies of Guinea, Rwanda, Senegal, Niger,

and Cape Verde Several new approaches to implementing public policiesare described in some detail, showing that it also is feasible to apply thosepolicies in poor countries with a weak institutional environment.

The most useful aspect of these case studies is that they provide ful ideas for implementing policies rather than just focusing on the prob-lems Without doubt, transparency and accountability help improve theapplication of programs, but some simple approaches to measurementalso make policies more effective For many government planners in less-developed economies, some ideas in these case studies can be useful forpolicy development

help-The best part of this book, therefore, is that it offers hope to ments that it is possible to successfully implement public policies focused

govern-on fiscal stabilizatigovern-on, ecgovern-onomic growth, and poverty reductigovern-on It is best

to approach this book as one that contributes to our knowledge of how

to make Richard Musgrave’s framework achievable

Jack M MintzProfessor of Business Economics,

J L Rotman School of Management, University of TorontoVisiting Professor, New York University Law School

April 2007

Public Finance for Poverty Reduction includes a series of papers that were

prepared in the context of a World Bank Institute (WBI) public financelearning program intended to build capacity in developing countries, with

a special focus on Latin America and sub-Saharan Africa The book places

a particular emphasis on the fiscal issues encountered by countries thatare in the process of implementing a poverty reduction strategy To definethe contents of the public finance learning program, numerous consulta-tions were conducted with practitioners in developing countries and withrepresentatives of the World Bank and the donor community These con-sultations identified the areas of interest and the demands for capacity en-hancement The following developing countries were involved in the dis-cussions and/or benefited from the course itself: Benin, Bolivia, BurkinaFaso, Ethiopia, Ghana, Guatemala, Guinea, Honduras, Kenya, Nicaragua,Paraguay, Senegal, and Zambia The learning program was prepared inpartnership with the governments of Belgium, France, Germany, andSpain, among others; and it received support from the University ofAntwerp (Belgium), Complutense University of Madrid (Spain), HarvardUniversity and Georgia State University (United States), the Institute ofFiscal Studies (Spain), and the group InWEnt (Germany)

xxi

The learning program benefited especially from the support of gium’s Directorate-General for Development Cooperation The publica-tion of the book was made possible by support from the Belgian PovertyReduction Partnership, a trust fund managed by the Poverty Reductionand Economic Management Unit (PREM) in the World Bank’s Africa re-gion The preparation of the case studies from Latin America benefitedfrom the support of the regional studies program of the Chief Econo-mist’s Office for Latin America and the Caribbean The case studies forsub-Saharan Africa were produced as background work for poverty as-sessments prepared by the World Bank.

Bel-The editors would like to thank Ishac Diwan, Robert Ebel, and VinodThomas, under whose direction the Public Finance and Poverty Reduc-tion WBI Program was launched to support countries implementing apoverty reduction strategy; Paula Donovan, Guillermo Perry, and SudhirShetty for providing their support for work on public spending andpoverty in Latin America and Africa; Jack Mintz for carefully reviewingeach chapter of the book and providing thoughtful comments; Vito Tanzifor his support and comments; Danny Leipziger for his support during thefinalization of this book at PREM; and José Manuel Gonzalez-Páramo,from the Board of the European Central Bank, for his contribution to theanalysis on the role of the state in developing countries The editors arealso grateful to Paul Cartier, Erwin De Wandel, and Harold Vandermeulenfrom Belgium’s Directorate-General for Development Cooperation, notonly for making the publication of this book feasible, but more generallyfor encouraging us to devote time and resources for capacity building forgovernment staff and researchers in partner countries

Finally, this book would not have been possible without the

profession-al editing of Christine Cotting from UpperCase Publication Services andthe services of Stephen McGroarty, Andres Ménèses, and Dina Towbin atthe Office of the Publisher at the World Bank

Blanca Moreno-DodsonQuentin WodonOctober 2007

AIPP Apoyo a Instituciones Públicas y Privadas (Uruguay)

(Uruguay)

CAIF Centros de Atención a la Infancia y la Familia

(Uruguay)

xxiii

DEO district education office

(Uruguay)

ENIGH Encuesta Nacional de Ingreso-Gasto de los Hogares

FONCODES Fondo Nacional de Compensation y Desarollo (Peru)

IDA14 the 14th replenishment of the IDA’s resources

INEI Instituto Nacional de Estadística e Informática (Peru)

MDRI Multilateral Debt Relief Initiative

MEF Ministry of Economy and Finance (Peru)

MEVIR Mejoramiento y Erradicación de la Vivienda Rural

Insalubre (Uruguay)

MINECOFIN Ministry of Economics and Finance (Rwanda)

MTSS Ministerio de Trabajo y Seguridad Social (Uruguay)MVOTMA Ministry of Housing and Transportation (Uruguay)

Development

(Uruguay)

PRONAA Programa Nacional de Asistencia Alimentaria (Peru)

SAAC Servicio de Asistencia Alimentaria Colectivizada

(Uruguay)

SIAV Sistema Integrado de Acceso a la Vivienda (Uruguay)SimSIP Simulations for Social Indicators and Poverty

All dollars are U.S dollars unless otherwise noted.

Governments in low-income countries have the difficult task of makingwide-ranging decisions about public spending, taxation, and borrowingwith the aim of helping their countries maintain long-term debt sustain-ability, achieve higher economic growth, and ultimately reduce poverty.Making such decisions is difficult because it involves considering multipletrade-offs There are at least four reasons why designing and implementingfiscal policies that contribute to growth and poverty reduction are partic-ularly challenging tasks in developing countries First, private-market fail-ures are widespread and often unpredictable Second, government and in-stitutional failures also limit the effectiveness of public interventions.Third, raising public revenues is difficult in a context of macroeconomicand growth instability, high debt ratios, weak tax administration, and largeinformal sectors Finally, many developing countries lack the data neces-sary to conduct a thorough analysis of the effect of government policies onthe poor segments of the population.

Despite those challenges, however, the budget remains one of the mostimportant instruments (together with laws and regulations) that govern-ments have at their disposal to foster poverty reduction Policy makers inboth developing and developed countries, as well as nongovernmental or-

Public Finance for Poverty Reduction

An Overview

Blanca Moreno-Dodson and Quentin Wodon

1

ganizations and providers of aid, can benefit from a deeper understanding

of how internally or externally financed public funds channeled throughthe budget can be used more successfully to benefit the poor in a realisticmanner

To set the stage for the chapters that follow—chapters that addresspublic financing and poverty reduction—we start here with a brief dis-cussion of the rationale behind the role of the government in public fi-nance Then we discuss some of the limitations faced by governments indeveloping countries We follow those discussions with an overview ofthe nature and structure of the material presented in this book and withour thoughts on germane topics yet to be addressed adequately

Rationale for the Role of Government

Before analyzing the appropriate levels of public spending, taxation, anddebt in a particular country context, it is worth asking why it is even per-tinent for governments to play a role that promotes growth and povertyreduction

Believing that competition and the profit motive would lead individualspursuing their private initiatives to serve the public interest, many econo-mists have argued for the government to play a limited role in this regard.According to their view, its role should be constrained to correcting marketfailures and providing basic public goods, including law and order, nationaldefense, and basic physical infrastructure.1 Other economists, however,have advocated much wider government interventions—among them, pro-moting income equality It is widely accepted that well-designed govern-ment institutions are necessary for country development; but the task ofdefining the most suitable size and type of government, and the right mix

of markets and government activities, remains difficult

A starting point in this discussion is recognizing that there are at leastthree reasons for government involvement in a market economy: (1) to es-tablish the preconditions for markets to operate efficiently, (2) to correctmarket failures, and (3) to improve social welfare and promote equity.First, governments need to set up the preconditions for markets to op-erate efficiently by creating the necessary institutions, laws, and regula-tions that will facilitate their functioning Where government interven-tion in areas such as property rights and competition laws is lacking, some

market activities may not develop at all, or they may develop in an cient manner with impossibly high entry costs or administrative and legalbarriers.

ineffi-A second reason for governments to intervene is to correct market ures In a general sense, these failures refer to a set of conditions underwhich a market economy does not allocate resources efficiently Correct-ing such a situation requires that the government assist the “invisiblehand”2to approximate what the market would have done in the absence

fail-of market failure There are various types fail-of market failures, each ing different forms of government intervention (World Bank 1997) Inthe case of public goods, for example, the market usually fails to definethe charge that individual consumers should pay for their use Here thefunction of the government to overcome that failure would be revealingthe citizens’ preferences for public goods—preferences often expressedand channeled through the political process

requir-Closely related to public goods is the concept of externality—therecognition that consumption or production of some goods may generatepositive or negative external effects for the society that are not reflected

in their price This argument has often been used to justify a ment’s role on the grounds that, without such intervention, the marketwould overproduce or underproduce those goods, depending on whetherthe externalities were positive or negative In addition, market failures of-ten are associated with incomplete markets and imperfect or asymmetricinformation among consumers and suppliers Markets may not providegoods or services whose costs are less than what consumers are willing topay.3Similarly, imperfect and asymmetric information may lead to an er-roneous valuation of goods and services, and therefore to inadequate sup-ply or demand Finally, market failures are related to problems of adverseselection and moral hazard when buyers or sellers act exclusively on thebasis of their own benefit and to the detriment of the general interest.4The third and equally important rationale justifying government inter-vention refers to the concern for distributive justice or equity Even ifmarkets could function efficiently, by their nature they would not ensurethat growth and income are distributed in a fair or just manner Govern-ment thus should play a role in income distribution, without compromis-ing the efficiency of the markets to allocate resources Welfare economicsconsiders the function of the government as going beyond the provision

govern-of public goods and focusing on the distribution govern-of income

Although the concern for equity is typically associated with the role ofgovernment, this does not mean that only the government should orcould contribute to reducing poverty If one thinks of poverty as resultingfrom a lack of opportunities, empowerment, and social protection, it isclear that the government is not solely responsible for filling that lack.5Infact, the private sector does play an active role in creating economic op-portunities (employment, credit), promoting inclusion of all members ofthe civil society (associations of private sector producers, workers, parents

of students, and the like), and protecting citizens (education, health care,and social protection, with or without public sector involvement in fi-nancing or delivery), thus contributing to reducing poverty eitherthrough its independent actions or by association and partnership withgovernment activities

The three reasons for government intervention described above suggestthat there is substantial scope for government action, particularly incountries where poverty is widespread and only some segments of thepopulation benefit from growth and development There is a growingawareness and global consensus about the need to increase efforts to com-bat poverty more vigorously by providing opportunities and assets forpeople who are less well-off on equity grounds In addition, empirical re-sults generally suggest that improvements in income distribution maycontribute to greater economic growth, faster development, and lesspoverty Inequality often produces insecurity and crime, which are nega-tive externalities with detrimental economic and social effects both na-tionally and globally

Limits to Government Intervention in Developing Countries

Several features distinguish the government from the private sector ernments have both strengths and weaknesses that must be understood

Gov-in an effort to decide what functions they should perform On the tive side, in democratic countries the people who run public institutionsare elected or are appointed by an elected official This makes them legit-imate in the eyes of the population In addition, the democratic govern-ment is endowed with certain rights that private institutions do not have

posi-—such as imposing taxes on citizens; seizing private properties for publicuse; and prohibiting, punishing, and requiring participation These capac-ities can be exercised because government institutions have two unique

features: cohesion and universality (Stiglitz 1995; Tanzi 1998) In somecircumstances, governments may be able to curb negative externalitieswhen the private sector, acting alone, cannot.

On the negative side, however, the government also faces limitationsthat differ from those of the private sector First, the political process it-self imposes restrictions because the mandate of the government often isvague and subject to political pressure from interest groups Even the ex-istence of externalities would not justify public action if externalitieswere politicized to justify inappropriately large government interven-tions Second, other restrictions are associated with the difficulty in pre-dicting changes in the external environment and, more particularly, in theprivate sector reaction to a changing world, as well as in gathering infor-mation reflecting the results of private or public actions Third, the rulesgoverning public institutions often are more rigid than those of the pri-vate sector because of the fiduciary responsibilities the government bears

to the population and the complexity and interaction of the many tives being pursued in the name of public interest All such limitationsmay reduce the efficacy of government interventions

objec-Thus, if there is agreement to say that markets are fully efficient onlyunder fairly restrictive assumptions (many of them nonexistent in devel-oping countries), there is also recognition that government failures limitthe effectiveness of a government in correcting market inefficiencies Forthat reason, many economists argue that the government should focus onareas where market failures are most significant and where the conditionsensure that it can make a difference In addition to government failuresand difficulties in adjusting to a changing environment, there are institu-tional failures related to the gap between government goals and the avail-ability of existing policy tools to pursue those goals That gap leads policymakers to use public policy instruments whose efficiency is less than ide-

al Moreover, for the government to perform its essential tasks, public stitutions must be guided by the appropriate incentives If public institu-tions are used by individuals for their own ends and to the detriment ofthe general interest, the government becomes an impediment to econom-

in-ic activity, progress, and development

When assessing the role of government, we must divide its functionsinto two broad categories: the government as a provider and the govern-ment as a promoter/facilitator/partner Regarding its provider function,there is now evidence and widespread acceptance that ownership of reg-

ular production processes is not a sensible function for the government.The private sector obtains better results than does the government, even

in areas that previously were considered natural monopolies6 (energy,telecommunications), mainly as a result of technological changes Thegovernment, however, is better placed to provide such public goods asmacroeconomic stability, justice, external defense, a clean environment,and dispute resolution Also, the government often is better positioned toprovide protection from poverty or destitution and to defend individualrights and social stability (Drèze and Sen 1991) Now, not all these func-tions require the government to be a provider of goods or services be-cause many can be facilitated simply by regulations and the creation of anappropriate framework

Regarding the role of the government as a promoter/facilitator/partner,the nature of regulation is a key ingredient Regulations can become bene-ficial or harmful, depending on how they are used Necessary regulationsare those that enable activities to operate more efficiently and protect in-dividuals from risk and losses Necessary regulations include air and roadtraffic regulations, and drug and food safety norms Regulations also can beused in lieu of taxes to mitigate negative externalities, as in the case of en-vironmental regulations However, regulations may constitute an inferiorpublic policy instrument For example, regulation of harmful emissionsmay be inferior to using tradable pollution vouchers By creating a privatemarket for the right to pollute, the government may be able to channel thepursuit of self-interest to achieve a given reduction in pollution at mini-mum costs—an outcome that regulations may not be able to achieve.Damaging regulations are those that allow individuals to enter an eco-nomic activity on favorable terms (by granting special concessions) toseek their own benefit to the detriment of the general interest, or to pur-sue objectives that are questionable from a social point of view; and thosethat are inefficient in the way they achieve well-justified social objectives.Regulations do not always represent an alternative to public spending.Pension reform is the clearest area in which government regulations thatencourage individuals to allocate part of their income to pensions trans-late into lower government spending However, in other areas, such as un-employment, sickness, or protection from other risks, regulations mayhave the opposite effect

In developing countries, governments face especially significant culties when, acting as providers or mere facilitators, they strive to estab-

diffi-lish the preconditions for markets to operate efficiently, correct for ket failures, and improve social welfare These difficulties are the result ofmany factors, including an uneven income distribution and a high per-centage of the population affected by severe poverty; a high degree ofvulnerability to external shocks of all kinds (for example, natural disas-ters, world prices, and aid dependency); numerous, pervasive, and unpre-dictable market failures resulting from imperfect information, prevalence

mar-of monopolistic practices, and different kinds mar-of negative externalities; alack of appropriate incentives for the private sector to operate in terms ofcompetition policy, regulatory framework, and the judiciary system; andgovernment and institutional failures resulting from weak capacity andrigidities, as well as problems of credibility and governance

In this context, one could conclude that there is a greater need for ernment intervention in developing countries However, a greater role forthe government does not necessarily mean the need for higher expendi-tures and the revenues required to finance them It is important to distin-guish between the size of the government measured quantitatively (per-haps as a share of gross domestic product [GDP]) and the positive rolethat government can have as assessed qualitatively In practice, althoughdeveloped countries show relatively higher ratios of public revenue andexpenditure to GDP than do developing countries, presumptively thisdoes not say much about the effectiveness of those governments There isevidence that the share of public expenditures in GDP in developedcountries has been increasing over the last decades This indicator doesnot reflect the “economic” role of the government because most of itsfunctions associated with legislation, the judiciary system, and macroeco-nomic and foreign trade policies typically represent only about 2–3 per-cent of GDP It is significant from the social point of view, however, be-cause the composition of those expenditures often reveals an increase insocial safety nets This result may be attributed to a number of factors,such as the importance of labor in the industrialization process, changes

gov-in the number and age structure of the population, and attempts to mote education and reduce income inequalities

pro-The results of those large expenditures in developed countries in terms

of improvements in income inequality and other social and economic dicators are not necessarily clear In other words, there is no obvious evi-dence that larger governments, if measured by public spending as the per-centage of GDP, have generated better social outcomes In some cases, an

in-increase in expenditures combined with a general public aversion to ing taxes have generated higher public deficits and larger debt-to-GDPratios in the developed world—something that typically must be avoided

pay-in developpay-ing countries, given the limited ability of these countries to pay their debt Furthermore, developing countries generally face greaterdifficulties in raising fiscal revenues to finance increasing public expendi-tures than do developed countries These difficulties often translate intomacroeconomic deficiencies—such as inflationary monetary financing,quasi-fiscal activities, high levels of debt, and deterioration of the govern-ment’s net worth—not always appropriately reflected in conventionalmeasures of fiscal deficits

re-Structure of the Book

The objective of this volume is to introduce its readers to key themes andsimple analysis techniques related to public finance and poverty It isbased on a Public Finance for Poverty Reduction program prepared at theWorld Bank Institute, in cooperation with the Poverty Reduction andEconomic Management Network at the World Bank The program wasdesigned for policy makers and researchers in both Latin America andsub-Saharan Africa.7 Case studies were prepared as part of the opera-tional work of the World Bank in both regions, primarily as backgroundresearch for poverty assessment or public expenditure reviews

The book first provides a set of four conceptual chapters addressingdebt, taxation, public expenditure tracking surveys, and benefit incidenceanalysis These chapters are followed by case studies on each theme, firstfrom Latin America and then from sub-Saharan Africa The idea behindcombining conceptual chapters and case studies is twofold: to providesome theory and background on key themes that are important in analyz-ing links between public budgets and poverty reduction, and to showconcretely how simple tools developed by economists can be used toshed light on the issues confronted by policy makers The book providesonly an introduction to the themes reviewed, given the very extensiveand complex literature on the topics covered An effort was made here topresent in simple ways the core principles and techniques as well as theempirical results from the case studies so as to make the book accessible

to a wider audience beyond economists

Thus, in this book we provide a discussion of some key techniques thatcan be used to produce public policies that improve the lives of poor peo-ple The techniques are related to the analysis of debt, taxation, and pub-lic expenditure (in the last case, with an emphasis on both tracking sur-veys and benefit incidence analysis) The objectives are not only to defineand explain concepts (in the first part of the book), but also to illustratehow those concepts are being used in practice (in the second and thirdparts devoted to case studies in Latin America and sub-Saharan Africa).What follows here is a brief overview of the discussions to come in therest of this volume.

Debt Sustainability

In poor countries, the need to balance short-term fiscal policies with term development goals (such as those expressed in the Millennium Devel-opment Goals) typically is associated with the government’s commitment

long-to implementing a poverty reduction strategy Particularly in sub-SaharanAfrica, this commitment takes place within the context of the debt reliefprovided under the Enhanced Heavily Indebted Poor Countries (HIPC)Initiative and more recently under the Multilateral Debt Relief Initiative(MDRI) Given this context, the first theme covered in this book is debtsustainability Along with taxation, monetary financing, internal borrow-ing, and quasi-fiscal activities, foreign debt historically has been one of themost important ways through which governments raise the resourcesneeded to implement their development policies In some cases, however,this has been a double-edged sword, given the need to repay the loans ob-tained from donors and other creditors Reliance on external debt was notalways determined by how much debt could be serviced and repaid, tak-ing into account real growth and international interest rates, and the use ofthe loans received did not necessarily provide poor people the greatestbenefit

One can refer to debt sustainability as the requirement that ness (or debt service) be kept in line with capacity to repay But a coun-try’s capacity is not easy to define Various approaches have been used inthe literature to define debt sustainability, including external, fiscal, andsolvency approaches Chapter 2 discusses these approaches and showshow they have been made operational through the HIPC Initiative In re-cent years, beyond the capacity of countries to repay, a greater emphasis

indebted-has been placed on the negative impact of high levels of debt (throughthe concept of debt overhang), as well as on the “human development”dimensions of debt sustainability Alternative approaches to analyzingdebt sustainability have been instrumental in bringing about additionaldebt relief to poor countries through the MDRI.

The basic concepts of debt sustainability are discussed and illustrated

in the cases of Paraguay for Latin America (chapter 6) and of Guinea,Rwanda, and Senegal for sub-Saharan Africa (chapter 10) The case stud-ies rely essentially on the traditional concepts of external and fiscal sus-tainability rather than on other alternative approaches discussed in chap-ter 2 Emphasis is placed on using simple examples to show how debtsustainability depends critically on various growth and taxation-spendingscenarios A simple debt simulation tool is used to perform complex sim-ulations easily The tool can be used by analysts to help the governmentand other actors identify some simple trade-offs between debt sustain-ability and key macroeconomic variables involved in the debt dynamics—variables such as growth, interest rates, inflation rates, exchange ratechanges, as well as fiscal and current account deficits and their impact onspending to alleviate poverty

Taxation

Taxation is the second topic discussed in the book Taxes are needed tofund public expenditure, and they have direct distributional effects Theexisting evidence, however, shows that, unless personal income taxes play

a greater redistribution role in developing countries, contributing to

equi-ty via taxation will be difficult Even when the personal income tax base

is developed, income tax competition from other countries and tax ministration limitations may constrain the government’s ability to use thetax system to redistribute income and wealth Nonetheless, the design ofspecific tax instruments should take poverty concerns into account—forexample, by exempting basic foodstuffs from such indirect taxes as thevalue-added tax A pro-poor exemption of that type could be offsetthrough higher indirect tax rates on luxury products Similarly, policies tomitigate the antilabor bias of corporate income tax in small and openeconomies can make tax policy more pro-poor In addition, broad-basedtax systems, with few deductions and exemptions (apart from a personalincome tax exemption not larger than per capita income, and low or zerotax rates on purchases of basic goods) and with relatively low tax rates

ad-(albeit proportional or moderately progressive in the case of the personalincome tax), compatible with administrative capabilities, are more likely

to provide a sound basis for economic growth

The conceptual issues related to taxation are discussed in chapter 3,which considers the following questions: What is the role of the tax sys-tem? What criteria can policy makers use in evaluating tax systems ingeneral and specific tax instruments in particular? What factors shouldpolicy makers consider in determining the aggregate level of taxes? Whatfactors should be considered in determining the relative use of differenttax instruments? How effective are different tax instruments in redistrib-uting wealth or income in a society? and When designing different tax in-struments, how effective are particular tax provisions in reducing the taxburden on poor people? Although there are no definitive answers for allthese questions, the discussion in chapter 3 offers some guidance.The case study of Latin American taxation presented in chapter 7 is de-voted to Mexico The study offers a wide-ranging evaluation of the per-formance of Mexico’s tax system over the 1980s and 1990s in several im-portant areas, including revenue adequacy, structure, temporal elasticity,stability and behavior over the business cycle, efficiency, and equity Thisevaluation includes a discussion of various hypotheses that may explainwhy the system has not performed as well as possible

The taxation case study for sub-Saharan Africa (chapter 11) is devoted

to Niger and is limited in scope Its main objective is to demonstrate how,even with limited available data, simple techniques can be used to ana-lyze the potential effect of indirect tax reforms on poor people Specifi-cally, chapter 11 provides first a review of medium-term targets for gen-erating public revenues in Niger (together with a description of thecurrent structure of tax revenues); then it uses household survey data toassess the potential distributional incidence of selected reforms underconsideration in the country in the first few months of 2005; and, finally,

it shows briefly how the overall impact of any tax reform depends in part

on how larger tax revenues are spent

Public Expenditure Tracking Surveys

There is broad agreement that the revenue side of fiscal policy can affectgrowth and poverty reduction positively, mostly by providing funds to fi-nance public spending, particularly in physical (basic infrastructure) andhuman (education and health care) capital to benefit poor people But in

the desire to avoid excessive interference from the state in the productivesectors and to minimize distortions in the economy, there also is broadconsensus that public expenditure is a more potent instrument to reducepoverty than is taxation itself Despite constraints on the absorptive ca-pacity of countries that lack institutional strength, there is ample room toimprove the allocation of public expenditure to reduce poverty in mostdeveloping countries.

The focus in this book is on public expenditure tracking surveys(PETSs) and the associated quantitative service delivery surveys (QSDSs)

As noted in chapter 4, studies suggest no close link between publicspending and outcomes, with higher spending not necessarily leading toenhanced services because leakage prevents funds from reaching schoolsand health clinics, and because waste and corruption often distort publicspending impact The PETS is useful in ascertaining the extent to whichpublic spending actually reaches households—and especially the poor.Implementing a PETS and publicly disclosing the results have beenshown to improve the allocation and use of funds in several developingcountries Better monitoring and tracking of funds have reduced leakage.These surveys demonstrate that data collection and analysis, and the sub-sequent dissemination of results, can be potent means of increasing trans-parency in the use of government funds and can give a stronger voice topoor people

Chapters 8 and 12 are devoted to surveys carried out in Peru andRwanda, respectively Poor targeting, deficient financial management, andleakage all were found to varying degrees in Peru The targeting of publicspending varied greatly from one social program to another The financialmanagement issues there included the volatility of central governmentfunding, insufficient transparency, and a lack of auditing and supervision

in municipalities’ use of funds The PETS was used specifically to ine leakage in the Vaso de Leche (Glass of Milk) program The greatestleaks were found not between the central government and municipalities,but at the local level

exam-In Rwanda, the survey was used to analyze the health care and tion sectors The study found delays in the transfer of public resourcesfrom the central administration to primary beneficiaries, and leaks at theregional and district-level health and education offices—again with weakaccountability, bookkeeping, internal financial controls, and auditing Inboth primary education and health care, allocations from the central gov-

educa-ernment only paid the salaries of teachers and health workers, so facilitiesrelied on household contributions, fees, and sporadic contributions fromdonors and nongovernmental organizations to fund their needs and activ-ities That reliance led to affordability issues and to a lack of such inputs

as student textbooks

Benefit Incidence Analysis

The final topic covered in the book is benefit incidence analysis, whichcan be used for both taxes and public expenditure This analysis combinesadministrative data (on taxes and/or spending, often at a disaggregatedlevel, such as primary rather than secondary and tertiary education) andhousehold survey data to measure how revenue and expenditure policiesaffect different groups of households The tool also can be used for otherpurposes, such as assessing the distribution of user charges in various sec-tors (such as education and health care, and basic infrastructure services)

As is noted in chapter 5, establishing the incidence of taxes and diture is important because those people who actually pay the taxes arenot necessarily those who bear the burden of the taxes Similarly, publicexpenditures that, in principle, are intended to benefit the poor may bebadly targeted and thereby benefit better-off households Subsidies forthe lower brackets of the tariff structure of electricity and water con-sumption provide a classic example: the subsidies are supposed to makeservices affordable for the poor, but because the poor tend to have verylow rates of connection to the electricity and water networks, the subsi-dies often end up benefiting the middle class instead These are the situa-tions that benefit incidence analysis is meant to identify Although suchexercise is important, it is not necessarily easy to implement It is not asimple matter to shift from a positive analysis of who benefits from pub-lic expenditure or who pays taxes to a normative judgment of the policychanges that should be adopted to improve the system

expen-Chapters 9 and 13 offer case studies on benefit incidence analysis inUruguay and Cape Verde, respectively The Uruguay chapter discusses arange of social assistance programs that use various targeting schemeswith quite different outcomes The chapter first organizes the programsaccording to their risk management role and then examines their per-formance, using indicators of costs, incidence, and targeting The discus-sion points to examples of good practice and to missed opportunities in