Lecture Note 12

Finance and Fiscal Policy for

Development
The Role of development banking

• The role of development banking

– Development banks are specialized public and private
financial intermediaries that provide medium- and long-
term credit for development projects.
• Problems with traditional banking
– Banks usually focus on either short-term lending for
commercial purposes (commercial and savings banks).

– Existing commercial bank set loan conditions that are

inappropriate for establishing new enterprises or for
financing large-scale projects.
• Major sources of capital of development banks.
– Bilateral and multilateral loans from national aid
agencies(e.g., U.S Agency for international
development(USAID) and from international donor
agencies like the World bank)

– Loans from the own governments

• Scale and structure of ownership
– By 2000, the number of development banks had
increased into the hundreds, and their financial resources
had ballooned to billions of dollars.

– 20% of the share capital of these banks was foreign-

owned, with the remaining 80% derived from local
investors.
• Criticism on the role of development banks

– Their excessive concentration on large-scale loans.

– Development banks remove themselves from the areas of

aid to small enterprises,
• Such aid is of major importance to the achievement of broadly
based economic development
 Informal finance
• Much economic activity in developing nations comes
from small-scale producers and enterprises.

– Most are non-corporate, unlicensed, unregistered,

enterprises,
– including small farmers, producers, artisans, and
independent traders operating in the informal urban and
rural sectors of the economy.
• Traditional commercial banks are both ill equipped
and reluctant to meet the needs of these small
borrowers.

– The sums involved are small (usually less than $1,000)

but administration and carrying costs are a large fraction
of that for large loans

– Few informal borrowers have the necessary collateral to

secure formal-sector loans
• Most non-corporate borrowers have to turn to
family or friends as a first line of finance and to
local professional money lenders, pawnbrokers, as
a backup.

– These sources of finance are extremely costly

– Money lenders charge up to 20% a day in interest for
short-term loans to traders and vendors.
• In the case of small farmers, the only collateral
that they have to offer to the money lender or
pawnbroker is their land or oxen.

• If these must be surrendered in the event of a

default, peasant farmers become rapidly
transformed into landless laborers,

– Money-lenders accumulate sizable tracts of land, either for themselves

or to sell to large local landholders.
 ROSCAs: Rotating Savings and Credit
Associations

• One type of informal finance found in Mexico, Bolivia,

Egypt, Nigeria, Ghana, the Philippines, Sri Lanka,
India, China, and South Korea

– A group of up to 50 individuals selects a leader who collects

a fixed amount of savings from each member.
• This fund is then allocated on a rotating basis to
each member as an interest-free loan.

– ROSCAs are often formed by married women, they can

improve women’s bargaining power in the family

• The funds are made available through membership

in the ROSCA, they cannot be withdrawn until the
wife wins a turn.
– This prevents the husband’s access to her savings
• Conflict of interest between the husband and the
wife

– The husband wants immediate consumptions

– The wife wants to use savings to purchase her targeted
item, such as a sewing machine.
 Microfinance Institutions

• Microfinance: the supply of credit, saving vehicles,

and other basic financial services made available to
poor and vulnerable people.

• Microfinance institutions (MEI) specialize in

delivering these services, in various ways and
according to their own institutional rules
 Group lending schemes v.s
Village banking
• Two important models in microfinance:
– Group lending schemes (solidarity group lending)
– Village banking
• Both use social relationships as a substitute for
physical collateral.
• But they differ in who owns the funds, how loans
are delivered, and how responsibility is shared.
 Group Lending Schemes – Core
Idea
• Individual loans backed by joint liability of a small
group.
• Typical group size: 3–5 or up to 10 borrowers.
• Uses peer selection, peer monitoring, and peer
pressure instead of traditional collateral.
 Group Lending Schemes – Main
Features
• External lender (MFI, NGO, bank) lends directly to
each individual borrower.
• Group members guarantee each other’s loans (joint
liability).
• If one member does not repay, others must cover
her payments or lose access to future loans.
• Frequent group meetings for repayment and
training.
• Often uses sequential lending: a few members
borrow first; others qualify after a good repayment
record.
 Village Banking – Core Idea

• A community-owned “village bank” manages a

common loan and savings fund.
• Residents form a village bank or credit cooperative.
• The fund is on-lent to individual members.
 Village Banking – Funds and
Ownership
• An external agency provides seed capital (start-up
fund) to the village bank.
• Members contribute compulsory savings;
repayments and interest build up the fund.
• Over time, the loan fund becomes a form of
community-owned capital.
• The long-run goal is a self-managed, locally
sustainable financial institution.
 Village Banking – Governance
and Responsibility
• Village bank has its own committee or board
(president, treasurer, etc.).
• Members collectively decide on loan approval,
interest rates, and use of surplus.
• Responsibility is based on village-level norms and
internal rules, not only small solidarity groups.
• Emphasis on building financial skills and community
self-reliance.
Potential Limitations of Microfinance:
as a development strategy
• Microfinance is largely marketed as financing for
microenterprises
– Poor people may prefer a regular wage and
salary to running a risky microenterprises
– The primary problem may be the lack of
available jobs paying a steady wage
– Microcredit may prove to be a transitional
institution

• Microenterprises never grow sufficiently to become

small or medium enterprises
 Potential Limitations of Microfinance:
as a development strategy
• Microfinance is a poverty alleviation strategy
– But many problems cannot be solved by solely relaxing
credit constraints
– Other activities, such as agricultural training, can be
underfunded

• Microfinance needs to be complemented with other

growth, poverty reduction, infrastructure building
and job creation policies.
 Fiscal policy for development

• Financial policy deals with money, interest, and

credit allocation,
– Fiscal policy focuses on government taxation and
expenditure

• Developed countries of the OECD collect a much

higher percentage of GDP in the form of tax revenue
than developing countries do.
Table 15.2 Comparative Average Levels of Tax
Revenue, 1985–1997, as a Percentage of GDP
Table 15.3 Comparative Composition of Tax
Revenue, 1985–1997, as a Percentage of GDP
• In the period 1995-1997, developing countries
collected 18.2% of GDP in tax revenue, while
OECD countries collected more than double this
share, 37.9%.

• Direct taxes-those levied on private individuals,

corporations, and property-make up 20% to 40%
of total tax revenue for most LDCs.
• Indirect taxes, such as import and export duties
and excise taxes (purchase, sales) constitute the
primary source of fiscal revenue for LDCs.

• Developed OECD countries generally rely more

strongly on direct taxes

– this pattern is much less pronounced in Europe, where

reliance on indirect taxes is almost as great as on direct
taxes.
• The tax systems (direct and indirect taxes
combined) of many developing countries are far
from being progressive.

• In some countries, such as Mexico, they can be

highly regressive
– lower-income groups pay a higher proportion of their
income in taxes than higher-income groups
• Taxation in developing countries has traditionally
had two purposes:

-First, tax concessions and similar fiscal incentives

have been thought of as a means of stimulating
private enterprise.

-The mobilization of resources to finance public

expenditures is by far more important.
• Many LDCs face problems of large fiscal deficits
– a combination of ambitious development programs and
unexpected negative external shocks.

• Developing-world governments had little choice but to

undergo severe fiscal retrenchment.
– With rising debt burdens, falling commodity prices,
growing trade imbalances, and declining foreign private
and public investment inflows,
 Fiscal Policy for Development

• Personal income and property taxes

• Corporate income taxes
• Indirect taxes on commodities
• Problems of tax administration
 Personal Income and Property Taxes

• Personal income taxes yield much less revenue as a

proportion of GDP in less developed than more
developed nations.

• In developed countries, the income tax structure is

progressive;
– people with higher incomes theoretically pay a larger percentage
of that income in taxes.

• Most LDC government have not been persistent enough

in collecting taxes owed by the very wealthy.
• In countries where the ownership of property is
heavily concentrated,
– Property tax can be an efficient and administratively
simple mechanism both for generating public revenue and
for correcting gross inequalities in income distribution.

• In a World Bank survey, in only one of the 22 countries

surveyed did the property tax constitute more than
4.2% of total public revenues.
• The share of property taxes as well as overall
direct taxation remained roughly the same for the
majority of developing countries over the past two
decades.

– Due to the political and economic power and influence of

the large landowning and other dominant classes in many
Asian and Latin American countries
 Corporate Income Taxes

• Taxes on corporate profits, of both domestically and

foreign-owned companies, amount to less than 3% of
GDP in most developing countries,
– compared with more than 6% in developed nations.

• LDC governments tend to offer all sorts of tax incentives

and concessions to manufacturing and commercial
enterprises.
• Typically, new and foreign enterprises are offered long
periods (sometimes up to 15 years )of tax exemption

• In the case of multinational foreign enterprises, the

ability of LDC governments to collect substantial taxes
is often frustrated

– Locally run enterprises are frequently able to shift profits

to partner companies in counties offering the lowest levels
of taxation through transfer pricing.
 Indirect Taxes on Commodities
• The largest single source of public revenue in
developing countries is the taxation of commodities in
the form of import, export, and excise duties .

• These taxes, which individuals and corporations pay

indirectly through their purchase of commodities are
relatively easy to assess and collect.
• This is especially true in the case of foreign-traded
commodities, which must pass through a limited
number of frontier ports.

• The countries with extensive foreign trade typically

collect a greater portion of public revenues in the form
of import and export duties than countries with limited
external trade.
• e.g.)
– In open economies with up to 40% of GNI derived from
foreign trade, an average import duty of 25% will yield a
tax revenue equivalent of 10% of GNI.

– In countries like India and Brazil with only 7% of GNI

derived from exports, the same tariff rate would yield
only 2% of GNI in equivalent tax revenues.
• The ability of LDC governments to expand their
tax nets to
– cover the higher income groups and
– minimize tax evasion by local and foreign
individuals and corporations

☞ determine sufficient public revenues to finance

expanding development program