Paper Presentation

Tax reform, fiscal deficit and

macroeconomic outcomes in developing
countries
- By Sayantan Basu
- Mobile no. 9674874496
- E-mail – zurich197@gmail.com
- AMITY UNIVERSITY KOLKATA

by Unknown Author is licensed under

 INTRODUCTION
In developing countries, taxation, government expenditure and borrowing have to
play a very important role in accelerating economic development. In fact, fiscal
policy is a powerful instrument in the hands of the government by means of
which it can achieve the objectives of development. There are several peculiar
characteristics of a developing country which necessitates the adoption of special
fiscal policy which ensures rapid growth. There are vast and diverse resources,
human and material which are lying underutilized. Such countries have weak
infrastructure i.e., they lack adequate means of transport and communication,
roads, ports, highways, irrigation and power. They also lack technical knowhow.
Their population is increasing at an explosive rate which necessitates rapid
economic development to meet the requirements of the rapidly growing
population. Above all these countries suffer from deficiency of capital. They are
caught up in the vicious circle of poverty. In order to overcome these handicaps, a
suitable fiscal and taxation policy is called for.
 FISCAL POLICY
Fiscal policy consists of steps which the government takes on both, revenue and
receipt side of its budget, and its related rules and regulations respectively. It is
often said that fiscal policy means that part of government’s economic policy
which concerns itself with aggregate effects of government expenditures and
taxation on income, production and employment. Mrs. Hicks said that Fiscal
policy is concerned with the manner in which all the different elements the
manner in which all the different elements of public finance, while still primarily
concerned with the carrying out their duties (as the first duty of a tax is to raise
revenue), may collectively be geared to forward the aims of the economic policy.
Fiscal policy of the several policy tools of the government to deal from achieving
socio-economic objectives of the society to regulating the market mechanisms.
When the total tax revenues exceed government spending in any given year, it is
known as fiscal surplus while when the government spending exceeds the total
tax revenues it is known as fiscal deficit.

Thus, if unemployment is regarded as too high, income and expenditure taxes

may be varied to stimulate the level of aggregate expenditure (demand). The
overall effect on economic activity will depend on the size of the tax cut and the
value of the multiplier. Increasing government expenditure will raise the level of
activity by an amount equal to the change in expenditure times the fiscal
multiplier.

Fiscal multiplier: It is a coefficient that indicates by how much an increase in

fiscal expenditure affects the equilibrium level of income. For example, in the
simple Keynesian model:

Y=C+I+G

C = a + bY

I=I

G=G
The equilibrium value for income, Y is: Y = (1/1 – b) (a + I + G) = αA where A
is autonomous expenditure and a is the fiscal multiplier. The advocates of fiscal
policy argue that the changes in taxation together with transfer payments
proportional to the existing distribution of income are the appropriate weapons to
regulate aggregate activity and control business (trade) cycles. The use of fiscal
policy entails changes in the government’s budget including the possibility of
deficits. The conventional view is that the use of deficit finance in this situation is
perfectly proper though attention has to be given to the impact of this as well.
Thus fiscal policy is a tool of general macroeconomic policy that seeks to
influence the level of economic activity through the control of government
expenditure and taxation. Keynes advocated the use of deficit financing (that is, a
budgetary deficit where the government spends more than its revenue from
taxation) in the 1930s to effect a transition from a situation of mass
unemployment to one approaching full employment. Keynes argued that an
increase in government spending or reduction in taxes (an injection into the
economy) stimulates aggregate demand via the multiplier effect, thus, creating
jobs and increasing output (GNP) to satisfy that demand, raising national income
(from Y0 to Y1). If, on the other hand, the level of economic activity is too high,
the government enjoys the option of running a budgetary surplus, decreasing its
expenditure or increasing taxes (a leakage from the economy) to reduce aggregate
demand.
 MACROECONOMIC OUTCOMES OF FISCAL
POLICY IN DEVELOPING COUNTRIES
There are mainly two types of outcome of fiscal policy. They are :

FISCAL POLICY AND ECONOMIC GROWTH – The relationship between

fiscal policy and economic growth is best understood by keeping in mind the fact
that no modern economy can stay put; it either grows (even though moderately)
or declines and decays. Budgetary flows form an important portion of the flow of
funds of an economy and, therefore have a profound role in directing it’s
working. Stability of the economy helps it in achieving this objective because
investment decisions respond more favourably to an atmosphere of stability. With
stability the consumption expenditure does not fall below a certain minimum
level and forms a cushion against economic contraction.

FISCAL POLICY AND DISTRIBUTIVE JUSTICE – It is generally claimed

that the objective of distributive justice comes into conflict with that of economic
growth. It diverts purchasing power from richer to poorer sections of the
community, encourages consumption and diverts resources from investment and
feeds inflation.
 FISCAL DEFICIT
Fiscal deficit in the budget is an important measure of deficit. Fiscal deficit is
defined as excess of total budget expenditure over total budget receipts excluding
borrowings during a fiscal year. In simple words, it is amount of borrowing the
government has to resort to meet its expenses. A large deficit means a large
amount of borrowing. Fiscal deficit is a measure of how much the government
needs to borrow from the market to meet its expenditure when its resources are
inadequate.

Fiscal deficit = (Total Expenditure both on Revenue Account and Capital

Account) – (Revenue Receipts + Non-debt Capital Receipts).

Revenue account - A revenue account is an account with a credit balance. It

includes all the revenue receipts also known as current receipts of the
government. These receipts include tax revenues and other revenues of the
government

Tax revenues include the revenue earned by the government authorities by

levying direct and indirect taxes and duties. Direct taxes include income tax,
corporate tax and so on. Indirect taxes include Excise duties, customs duties,
and service tax. Other revenues include revenues from other sources of
investments like interest, dividends, profits from public sector units, fees,
fines and so on. Revenue expenditure includes expenses which are not used
for the creation of assets or repayment of liabilities. These basically include
current expenses of the government. For example, paying salaries, giving
grants are instances of revenue expenditure. It can further be divided into
plan and non-plan expenditure.

Capital account - A capital account is an account that includes the capital

receipts and the payments. It basically includes assets as well as liabilities of
the government. Capital receipts comprise of the loans or capital that are
raised by governments by different means.

They can also raise money from the public, such loans are market loans. They
could also borrow from banks or other sources by means of Treasury Bills,
 also called T-Bills. Loans are also raised from external sources like foreign
governments or international institutions. Another way of raising capital is by
disinvestment in public sector units or other assets.

Revenue receipts - Revenue receipts are the rights of a business to

compensation resulting from normal business operations and are recorded
when the business has earned the right to receive them. These receipts are
recurring and will affect the business's profit or loss on the income statement.
Generally, this means that once goods are delivered into the hands of the
customer or services have been substantially provided, the business has
earned the revenue. However, rents and interest payments received are also
considered revenue receipts. Regardless of whether cash is received, or an
accounts receivable balance is increased, these are still called revenue
receipts.

Non debt Capital receipts - Non-debt creating capital receipts are those
money receipts which are received by the government from the sale of old
assets. These receipts are not treated as liabilities of the government.
Examples of non-debt creating capital receipts are recovery of loans,
proceeds from sale of public enterprises, etc. Hence, it does not give rise to
debt.

Fiscal deficit can be financed by, firstly through borrowing by the govt from the
market (both internal and external), but the government also has to pay annual
rate of interest on the borrowing.
 PRIMARY DEFICIT
Another important concept of budgetary deficit is Primary deficit. It is a measure
of budget deficit which is measured by deducting interest payments from fiscal
deficit. Thus,

Primary Deficit = Fiscal Deficit – Interest Payments

Interest payments on public debt are made by government, which are also transfer
payments. “The difference between the fiscal deficit and the primary deficit
reflects importance of interest payments on public debt incurred in the past.”3 We
have seen that borrowing requirement of the government includes not only
accumulated debt, but also interest payment on debt. If we deduct ‘interest
payment on debt’ from borrowing, the balance is called primary deficit. It shows
how much government borrowing is going to meet expenses other than Interest
payments. Thus, zero primary deficits means that government has to resort to
borrowing only to make interest payments. To know the amount of borrowing on
account of current expenditure over revenue, we need to calculate primary deficit.
Thus, primary deficit is equal to fiscal deficit less interest payments. Fiscal deficit
reflects the borrowing requirements of the government for financing the
expenditure inclusive of interest payments. As against it, primary deficit shows
the borrowing requirements of the government including interest payment for
meeting expenditure. Thus, if primary deficit is zero, then fiscal deficit is equal to
interest payment. Then it is not adding to the existing loan. Thus, primary deficit
is a narrower concept and a part of fiscal deficit because the latter also includes
interest payment. It is generally used as a basic measure of fiscal irresponsibility.
The difference between fiscal deficit and primary deficit reflects the amount of
interest payments on public debt incurred in the past. Thus, a lower or zero
primary deficits means that while its interest commitments on earlier loans have
forced the government to borrow, it has realised the need to tighten its belt.
 RECEIPTS AND EXPENDITURE
RECEIPTS - Receipts of the government consists of categories and sub-
categories including tax and non – tax receipts. A probable criterion for the choice
of revenue items is that such receipts should not include subsequent repayment
obligations. This criterion includes tax receipts, fees, fines, dividends and profits,
escheats, receipts of grants.

In the receipts side of the government budget, its expenditures limits by the extent
it can raise resources through taxation, borrowing from the market and getting
new money printed. The government has to make a choice between the magnitude
of the taxation, borrowing from the market and using printed money to finance
the expenditure. The major receipts in the government budget is from taxation.

WHAT IS TAX – A tax is a compulsory payment levied on the person or

companies to meet the expenditure to meet the expenditure incurred on conferring
common benefits upon the people of the country. Two aspects of taxes follow
from the definition :(1) A tax is a compulsory payment and no one can refuse to
pay it. (2) Proceeds from taxes are used for common benefits or general purposes
of the state. This implies that individual cannot expect or demand that the
government should render him a specific service in return for the tax paid by him.
However, this does not imply that government does nothing for the people from
whom it receives taxes. According to Taussig “The essence of a tax, as
distinguished from the other charges by government is the absence of any direct
quid pro quo between the taxpayer and the public authority”.

Tax can be classified as direct tax and indirect tax. The distinction between
direct and indirect taxes is based on whether or not the burden of tax can be
shifted wholly or partly to others. If a tax is such that the burden cannot be shifted
to others and the person who pays it to the government has also to bear it, it is
called direct tax. Income tax, annual wealth tax, capital gains tax are example of
direct taxes

On the other hand, indirect taxes are those whose burden can be shifted to others
so that those who pay these taxes to the government do not bear the whole burden
but pass it wholly or partly to others. For instance, excise duty on the production
of sugar is an indirect tax because the manufacturers of sugar include the excise
duty in the price and pass it on to buyers. Ultimately it is the consumers on whom
the incidence of excise duty on sugar falls as they will pay higher price for sugar
then before the imposition of tax. Likewise, the sales tax on commodity can also
be passed on to the buyers in the form of higher price or commodities. Therefore,
excise duty on commodities are example of indirect taxes.

EXPENDITURE – Items included here are cost of running and maintain the state
administration itself, cost of providing various state services, salaries, subsidies,
grants, and so on. Public expenditure can be applied as a tool to raise aggregate
demand and hence, to get the economy out of recession. Even through variation in
public expenditure, aggregate demand can be managed to check to inflation in the
economy. It is also used to improve income distribution, for allocation of
resources in desired areas and to influence composition of national product. In
developing countries, the role of public expenditure is very significant. In the
developing countries, the variation in public expenditure is not only to ensure
economic stability but also to generate and accelerate economic growth and to
promote employment opportunities. The public expenditure policy in developing
countries also plays a useful role in alleviating mass poverty existing in them and
to reduce inequalities in income distribution.

CLASSIFICATION OF PUBLIC EXPENDITURE

Public expenditure is classified into different categories. They are as following:

REVENUE AND CAPITAL EXPENDITURE – Revenue expenditure is a

current or consumption expenditure incurred in civil administration (i.e. police,
jails and judiciary), defense forces, public health and education. It is recurrent
type, which is incurred year after year. On the other hand, capital expenditure is
incurred on building non-durable assets. It is a non-recurring type of expenditure
and is incurred on things such as building river projects, power plants, ports,
highways, steel plants etc., and buying machinery and equipment.
TRANSFER PAYMENTS & EXPENDITURE ON GOODS & SERVICE –
Transfer payments referred to those kinds of expenditure against which there is no
corresponding transfer of real resources (i.e., goods and services) to the
government. Expenditure incurred on old age pension, unemployment allowance,
sickness benefit, interest on public debt during a year are examples of transfer
payments because the government does not get any service or goods against them
in the particular year. On the other hand, expenditure incurred on buying or using
goods and services is a non-transfer payment as against such expenditure, the
government receives goods and services. It is therefore called expenditure on
goods and services.

DEVELOPMENT AND NON-DEVELOPMENT EXPENDITURES –

Another useful classification of public expenditure rests on whether a particular
expenditure by the government promotes development. All those expenditures of
government which promote economic growth are called developmental
expenditure. Expenditure on irrigation projects, flood control measure, transport
and communications, capital formation in agriculture and industrial sector are
described as developmental expenditure. On the other hand, expenditure on
defense, civil administration, interest on public debt etc., are put into category of
non-developmental expenditure. Expenditure on public education and health are
regarded as non-developmental expenditure and creates human capital which
promotes economic growth as much as physical capital, if not more.
 TAX REORMS
There have been major changes in tax systems of countries with a wide variety of
economic systems and levels of development during the last two decades. The
motivation for these reforms has varied from one country to another and the thrust
of reforms has differed from time to time depending on the development strategy
and philosophy of the times. In many developing countries, the immediate reason
for tax reforms, has been the need to enhance revenues to meet impending fiscal
crises. As Bird (1993) states, “…fiscal crisis has been proven to be the mother of
tax reform”. Such reforms, however, are often ad hoc and are done to meet
immediate exigencies of revenue. In most cases, such reforms are not in the
nature of systemic improvements to enhance the long run productivity of the tax
system.

One of the most important reasons for recent tax reforms in many developing and
transitional economies has been to evolve a tax system to meet the requirements
of international competition (Rao 1992). The transition from a predominantly
centrally planned development strategy to market based resource allocation has
changed the perspective of the role of the state in development. The transition
from a public sector based, heavy industry dominated, import substituting
industrialization strategy to one of allocating resources according to market
signals has necessitated systemic changes in the tax system. In an export-led
open economy, the tax system should not only raise the necessary revenues to
provide the social and physical infrastructure but also minimize distortions. Thus,
the tax system has to adjust to the requirements of a market economy to ensure
international competitiveness.
 TAX REFORMS IN DEVELOPING COUNTRIES
Given the low level of tax revenue and the contradictory structure of tax
legislation in many developing countries there is broad agreement on the need for
tax reforms in those countries. As the changing role of state in the developing
countries arose, increasing discussion, this has generated demand for
liberalization, deregulation and the withdrawal of public sector involvement in
those areas which might attract private sector investment. Thus it is recommended
that publicly owned enterprises producing goods and services which can have
their prices established via the market ought to be privatized. Taxation policy in
developing countries has also been coming in for critical scrutiny as a part of this
process.

A typical developing economy collects just 15 percent of GDP in taxes, compared

with the 40 percent collected by a typical advanced economy. The ability to
collect taxes is central to a country’s capacity to finance social services such as
health and education, critical infrastructure such as electricity and roads, and
other public goods. Considering the vast needs of poor countries, this low level of
tax collection is putting economic development at risk.

Only very few developing countries have managed to establish their tax system in
such a way to achieve an appropriate level of revenue and to keep tax generated
misallocation within tight bounds. In most of the countries neither has it possible
to finance the public expenditure nor have the tax systems operated in conformity
with economic policy objectives such as growth and combating poverty.
 CASE STUDY: TAX REFORMS IN GEORGIA
Introduction

The Georgian people decisively and proudly abandoned a socialist economic system, and since
1990 have faced new challenges to reorganize the nation’s economy into a market one. With
new institutional demands, Georgia needed to adopt a tax system to ensure the government’s
operations. Such a system needed to be successful both for economic development and for
sustainable state revenues. Several failures prior to 2004 led Georgia to abandon its previous
way of taxation and succeed with simplifying, cutting rates, and digitalizing the system. Tax
cuts accelerated the economy and the government’s revenues. This important change was
possible only after taking full responsibility of economic policy after several years of crisis and
stagnation, a high level of corruption and government mismanagement, and despite inaccurate
foreign advice.

Prior to the Reforms

Georgia had been using the Soviet tax system after the Soviet Union collapsed in 1991 until
1994, when it adopted its own tax laws. In 1997 it implemented a tax code based on the
International Monetary Fund’s (IMF) proposed tax system for nations transitioning from
communism towards market economies. This system was very artificial and did not reflect local
realities, intending only to support government tax collection efforts. From that time, the tax
code consisted of several different taxes, the total burden of which could reach as high as 50
percent. This tax system immediately became an opportunity for lobbying and seeking
privileges. The complexity of the tax code became a reason for tax avoidance, bred corruption,
and resulted in taxpayers being overly burdened. From 1997 to 2003, the government made
more than 300 amendments to the tax code, with more than 2,000 clauses. It was impossible to
follow how and when to pay taxes according to the tax code. Tax authorities also had trouble
collecting taxes for the same reasons. Instead, both sides became involved in unofficial tax
payments—some in the form of lump sum payments and others in the form of bribes.
Therefore, the number of taxes and their rates became disconnected from actual tax collections.
Instead, the tax system became an extreme burden to taxpayers and a drag on the Georgian
economy. This environment attracted very risky people who often resorted to bribery and
breach of contract, even if it meant being imprisoned. Hiding business activities was the rule,
not an exception. Labour reimbursement was also taxed very heavily at 20 percent. In fact,
labour income was supposed to be taxed at rates from 12 to 20 percent in a progressive manner,
but this was only a formality, and everybody paid 20 percent. In addition, every worker’s salary
was also taxed, with social insurance taxes of around 31 percent. This meant around 60
Georgian Lari of tax was paid for each 100 Lari in salary. In many cases employers would pay
dividends to their workers instead of salaries, which allowed them to pay only 39 Lari in taxes
per 100 Lari. For instance, a bread factory in Kutaisi employed 500 workers to whom the
factory owners paid only dividends. A poor and burdensome taxation system along with
extremely limited economic freedoms (Georgia’s rank in the Economic Freedom Index in 2002
was 93rd) resulted in economic depression, which lasted many years after the collapse of Soviet
Union. GDP per capita couldn’t rise to even one-third of Soviet levels, and stayed at a level
below $1,000 U.S. Figure 1 shows the decline and then the rise of Georgia’s economy:

The Reform Effort

In 2001, the Georgian government decided to reform the tax system. Together with some
industrial groups, the government asked local experts to create a draft of a new tax code. The
group of six (of which the author of this article was a member) was led by a Georgian
economist, the late Niko Orvelashvili, who enthusiastically worked to recreate Georgia’s tax
system. The group of experts consulted with hundreds of specialists of taxation, customs,
accounting, and law. The group created a conceptual framework for a new code, which was
meant to establish an environment of free entrepreneurship, legality, and efficiency. The group
proposed the following principles and goals for the reform effort:
• Simplifying the tax system radically by decreasing the number of taxes and tax rates, thereby
cutting the total tax burden in half or more, and making tax payment easier, thereby eliminating
the need to pay bribes and reducing risk overall.
• Eliminating double taxation, abuse of tax rules by the government, and all privileges and
special rules for any sectors or companies.
• Eliminating special taxes (social, road, environment).
• Tax rules should correspond to the human rights protections enshrined in Georgia’s
constitution.
• The burden of proof in tax disputes should reside with the government, not the taxpayer, as is
the case in all other disputes.
 • All tax rules should be clearly described in the tax code.
• Tax rules should be clear, long-run, rational, stable, and predictable. The prepared draft
passed one hearing but was not adopted because of the opposition of special interest groups.

Following the Rose Revolution in 2003, the new government in 2004 swore to improve the
business environment, and in 2005 implemented the new tax code. It used almost all the above
principles. The following table shows which taxes remained after the reform and how rates
were changed.
The tax reform continued with several improvements. One of them is the rule of 100 percent
depreciation of purchased assets. This investment-friendly rule was later strengthened by
another rule—the so-called Estonian model of not taxing profit if re-invested (in force from
2017).

The Results
Implementation of the new system was ensured by the work of the former minister of Reforms
Coordination, the late Kakha Bendukidze. The fiscal outcomes of the reforms were incredible,
though predictable. All types of taxes (except customs tax) increased the related state revenues:
Value-Added Tax revenues increased by more than seven times, personal income tax revenues
increased by more than eight times, and profit tax revenues increased by 10 times.

Figure 3 illustrates this tendency.

The reduction of the tax level triggered higher tax revenue in Georgia, indicating that the
country’s pre-reform tax burden was too far towards the right (or the top, depending on the
orientation of the graph) on the Laffer curve (Fig. 3.1)

The improvement of the economy was tremendous. GDP doubled during the first four years
and tripled in the first eight years of the reforms (despite the decline in 2009). The success was
the result not only of tax reform but also of more complex and wider ranging reforms, including
deregulation, liberalization, and limiting of government powers. The supply-side effects of the
tax cuts further increased state revenues as shown in Figure 4. Wage growth also accelerated
following the reforms.
 Conclusion
The success of the tax reforms in Georgia is very strong evidence that even nations with a bad
historical experience and the most intense economic crises can solve their problems using free
market solutions. The story of Georgia should be an example to all developing nations that any
country with the will to do so can take charge of its own tax system and, without the aide or
interference of international organizations, create the conditions for economic growth and
prosperity.
 BIBLIOGRAPHY

1) BOOKS –
- HL BHATIA – PUBLIC FINANCE
- HL AHUJA – MODERN ECONOMICS
- RICHARD AND PEGGY MUSGRAVES – PUBLIC FINANCE IN
THEORY AND PRACTICE
2) WEBSITES –
- https://taxfoundation.org/tax-reforms-in-georgia-2004-2012/
- https://www.toppr.com/guides/economics/government-budget-and-the-
economy/revenue-account-and-capital-account/
- https://bizfluent.com/info-7783153-revenue-receipts.html
- https://www.toppr.com/ask/question/nondebt-creating-capital-receipts-give-rise-to-
debt/