1. Fiscal Space, Fiscal Legitimacy and Development
G20 Workshop on Fiscal Space for Growth and Social Policy
19-20 June 2008
Buenos Aires
Javier Santiso
Director & Chief Development Economist,
OECD Development Centre

2. 2 3 1 Introduction Fiscal Space and Growth
Fiscal Legitimacy and Development

3. The Development Centre
Bridging OECD and Emerging Economies
OECD members
members
Non-OECD members
members
Chile
South Africa
India
Thailand
Egypt
Israel
Brazil
Romania
Vietnam
Colombia

4. Latin American Economic Outlook impact
LEO
Latin American Economic Outlook impact
Activities:
11 seminars organized on topics related to Latin America
50 presentations at international conferences
235 press articles published in 18 countries
members of LEO’s newsletter

5. OECD Centre for Tax Policy & Administration
Partnership
OECD Centre for Tax Policy & Administration
Enlargement Initiative
Latin American Revenue Statistics Project:
An initiative to extend the OECD Revenue Statistics methodology to a number of Latin American countries.
Mission:
Providing Technical Expertise to the Committee on Fiscal Affairs by examining all aspects of taxation.
Covers international and domestic tax issues, direct/indirect taxes, tax policy and tax administration.
Provide annual comparisons on tax levels and tax structures in member countries.
Recent work on environmental policy and taxation, taxation and growth.
The OECD’s Centre for Tax Policy and Administration (CTPA) is the focal point for the Organisation’s work on taxation.The Centre provides technical expertise and support to the Committee on Fiscal Affairs and examines all aspects
of taxation other than macro-fiscal policy, which is dealt with by the Economic Policy Committee. Its work covers
international and domestic tax issues, direct and indirect taxes, tax policy and tax administration. The Centre’s statistical
publications provide annual comparisons of tax levels and tax structures in member countries and the Centre is also responsible for the OECD Tax Database, which has a description of the main parameters of each member country’s tax system. The Centre contributes to the work of other committees of the OECD in projects which have a strong tax component. Recent examples include input into work on the use of tax instruments to achieve environmental policy objectives, analysis of the impact of taxation on the functioning of labour markets and an examination of the link between
taxation and growth.

6. 3 1 Introduction 2 Fiscal Space and Growth
Fiscal Legitimacy and Development

7. Understanding Fiscal Space
Growth
Understanding Fiscal Space
Fiscal Space
“The capacity of a government to provide financial resources for a desired purpose, subject to the constraint that the fiscal position is sustainable, both over the medium and long-term.”
Heller, P. Introduction to “Fiscal Policy: Fiscal Elements of Growth and Development”. Proceedings of G-20 Workshop. Istanbul, Turkey, July 2007.
“The gap between the current level of expenditure and the maximum level of expenditures a government can undertake without impairing its solvency”
Development Committee of the World bank-IMF Board on Fiscal Policy and Growth, 2006.
The four pillars of Fiscal Space
 Usually, the idea is that in creating fiscal space, additional resources can be made available for some form of meritorious government spending (or tax reduction) (Heller, 2005).
The incentive for creating fiscal space is strengthened where the resulting fiscal outlays would boost medium-term growth and perhaps even pay for itself in terms of future fiscal revenue.
Explicit in the definition is the link to the concept of fiscal sustainability. This relates to the capacity of a government, at least in the future, to finance its desired expenditure programs, to service any debt obligations and to ensure its solvency.
Source: Fiscal Policy: Fiscal Elements of Growth and Development”. Proceedings of G-20 Workshop. Istanbul, Turkey, July 2007.

8. Affected drivers of growth: Employment, Human Capital Formation
Tax structure and channels of growth
Taxation
Income taxes and
Social Security
Consumption Taxes
Taxes on Property
and Wealth
Companies
Different aspects of a tax system tend to have a particular impact on growth through some of these channels
In order to create “fiscal space”, the impact of different tax policies on the drivers of growth needs to be assessed.
The most common elements of a tax system are presented in the graph. Each of these has a channel through which they are most likely to affect economic growth.
The highlighted taxes, for instance, denote those taxes more likely to affect two main growth drivers: employment and human capital formation. Other levels of disaggregation permit to see other drivers of growth that are affected by a specific tax structure.
Households
Profits
Special
tax
SSC
employer
SSC
employee
Capital
Income tax
Labour
income tax
General taxes
(e.g. VAT)
Taxes on specific
goods and services
Property
State tax
Wealth
Tax
Affected drivers of growth:
Employment, Human Capital Formation
Source: Heady, C. “Tax Policy for Growth.” In Fiscal Policy: Fiscal Elements of Growth and Development”. Proceedings of G-20
Workshop. Istanbul, Turkey, July 2007.

9. Tax structure is a creator of fiscal space
Growth
Tax structure is a creator of fiscal space
Tax revenues are one important component of fiscal space, not only because it affects the deficit financing, but also because it has an impact on government resources devoted to achieve “high priority” goals.
Traditionally, governments have looked for optimal tax structures that would allowed them to have coverage, steady growth and public financial sustainability.
Important differences remain in terms of tax structure between LAC and OECD countries. Taxes on income, profits and capital gains are much higher in the OECD area than in Latin America, so as Social Security contributions. There is room for further improvement regarding the optimal tax structures for LAC economies that guarantee both revenues and welfare.
There are different ways in which a government can create fiscal space. Additional revenues can be raised through tax measures or by strengthening tax administration.
Tax revenue statistics in Latin America suggests that there is a considerable fiscal gap between OECD and Latin America. There are reasons for this: tax evasion, poor tax administration (e.g. weak enforcement technology, no tax auditing, absence of tax morale).
These are elements that need to be regarded when considering to extend fiscal space.
Source: Latin American Revenue Statistics (LARS), OECD Development Centre, Paris. Based on data from ECLAC and OECD.

10. Corporate taxes and Investment
Growth
Tax Policy and Growth: Implications
Corporate taxes and Investment
Income taxes
The study on “Taxation and Growth” by the Tax Centre stresses two policy conclusions regarding corporate and income taxes:
First, cutting corporate taxes could positively affect investment. It is possible that product market regulations and large administrative burdens on firms can make investment decisions less responsive to taxes.
Second, regarding personal income taxes, countries with a large share of industries with high turnover rates can gain from reforming their top marginal tax schedule. However, this could increase inequality (we look at it in the next section). Furthermore, reforming labour/SSC taxes could be more important for productivity in countries with a labour intensive industry structure.
Source: Latin American Revenue Statistics, OECD Development Centre, Paris.
Reforming top marginal tax schedules may improve incentives: it could also increase inequality.
Reforming labour/SSC taxes is more important for productivity in labour-intensive economies.
Cutting corporate taxes may promote productivity growth and investment.

11. Does the tax structure matter for growth?
Tax “negative effect” of tax on growth declines as you move from :
Corporate income tax
Personal income tax
Consumption taxes
Property tax   
Macro findings suggest a “ranking” of taxes in terms of their negative impact on GDP per capita: property taxes (particularly recurrent taxes on immovable property) < consumption taxes < personal income taxes < corporate income taxes.
Other implications toward growth enhancing policies (mentioned in the Tax Centre report):
Tax progressivity may reduce GDP per capita, from a purely growth perspective.
Broadening the base of consumption taxes is better for growth than increasing rates.
Limited scope to improve growth through multiple consumption tax rates.
In-work tax credits can promote growth by increasing participation rates.
Questions :
To what extent do different tax provisions affect investment and productivity?
Does the industry/firm structure matter for the impact of taxes?
Is there a trade off among efficiency, equity, and simplicity?
Source: Arnold, J., A. Johansson, C. Heady, B. Brys and L. Vartia. “Tax and Economic Growth”. OECD Centre for Tax Policy Administration /Economics Department Working Paper, 2008

12. 1
Introduction 2
Fiscal Space and Growth 3
Fiscal Legitimacy and Development

13. Latin America’s fiscal stance has improved
Legitimacy
Latin America’s fiscal stance has improved
Fiscal reform has strengthened institutions but failed to raise more revenue
Source: Latin American Economic Outlook 2009 (forthcoming). Information based on investments banks' publications, 2008
Note: countries analysed are Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay and Venezuela during the period July February 2008, covering 15 presidential elections before 2006 and 8 presidential elections since 2006 (non overlapping elections).
Source: OECD Development Centre, Based on Nieto and Santiso (2008).
Note: Difference calculated for each period between primary spending in election-year and average on primary spending of the last three non-election years prior to election. 13

14. Tax revenue for selected countries (Central Government, % GDP, 2006)
Legitimacy
However, fiscal recipes remain low
Tax revenue for selected countries
(Central Government, % GDP, 2006)
Fiscal reform has strengthened institutions but failed to raise more revenue
Source: Latin American Economic Revenue Statistics, OECD Development Centre, Paris. Based on ECLAC’s ILPES Database and OECD Revenue Statistics Database. 14

15. Inequality before and after taxes and transfers
Legitimacy
Fiscal Progressivity is not a matter of DNA
Inequality before and after taxes and transfers
Gini coefficient
There is no Latin curse: Quality fiscal policy is not a matter of DNA
A central reason why fiscal legitimacy is so low in Latin America is that fiscal systems do not have a progressive distributional impact.
Here, it is useful to compare Latin America with Europe:
=> Inequality in Latin America before taxes and transfers is similar to that in Europe.
But the impact of taxes and transfers in reducing inequality is significant in Europe.
This is not the case in Latin America.
This difference in fiscal impact explains why inequality is much lower in Europe than in Latin America.
Source: Latin American Economic Outlook OECD Development Centre, Based on data by Goñi, López, and Servén (2006). 15

16. Fiscal Legitimacy is low
% of citizens who trust
tax revenue is well spent
( )
Firms’ assessment of the
neutrality/composition of government decisions/spending ( )
Fairer/
Wiser
We define fiscal legitimacy as the % of survey respondents who trust that tax revenue in their country is well spent.
Because this information is from household surveys, it is more representative of taxpayers’ views than are indicators of the quality of public policies, which are based on surveys of the opinions of business managers and experts.
We would have liked to compare our results for Latin America with a number of countries in Europe, like Spain, and Ireland, but unfortunately Euro-barometer does not seem to collect such information.
Unfair/ Wasteful
Source: “Latin American Economic Outlook 2008”. OECD Development Centre, Based on Latinobarómetro (2003, 2005) and World Bank Institute, Governance Indicators Database. Based on World Economic Forum, Global Competitiveness Report, 16

17. More than quantity, is the quality of spending
Legitimacy
More than quantity, is the quality of spending
To a certain degree Latin America’s poor performance can be attributed to a lack of investment on public education. Except for Uruguay, Latin American countries perform poorly in terms of public investment given their level of development. But even considering their level of investment, there are plenty of countries with similar levels of investment but significantly better scores.
Source: OECD Development Centre, Based on PISA (2003) and OECD Education at a Glance (2005)

18. Equity matters: Spending is often regressive
Legitimacy
Equity matters: Spending is often regressive
But equity matters as well: In many cases social spending is regressive
Fiscal legitimacy interacts closely with democratic legitimacy, in both directions. (Even though there are, of course, other determinants of democratic legitimacy as well.)
For example: when populists in Peru -- or perhaps even in Mexico -- win the support of a significant proportion of the population, despite strong growth and good economic conditions, it reflects a lack or weakness of democratic and fiscal legitimacy.
Source: Latin American Economic Outlook, OECD Development Centre, Based on ECLAC’s Panorama Social, 2007. 18

19. Growth, Fiscal Policy and Development
Conclusions
Growth, Fiscal Policy and Development
Fiscal Space is not one-dimensional.
Improving the social contract between citizens (and firms) and the state – fiscal legitimacy – will also broaden fiscal space.
Best practices can be identified to promote growth, equity and the quality of public services.
Fiscal policy must improve the quality (and the quantity) of revenues and expenditures.
Tax administration matters: weak administration limits the ability to:
- raise revenue
achieve a balanced tax structure
engage citizens in a tax-paying democracy
Fiscal policy is a powerful tool to promote democratic participation
This difference also shows up in comparisons of quality and quantity of public spending on eductation. 19

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Fiscal policy is a powerful tool to promote democratic participation
This difference also shows up in comparisons of quality and quantity of public spending on eductation. 20