Aid, tax and state building

There is undoubtedly a role for foreign aid, but it cannot match the revenue-raising, democracy-strengthening potential of tax.

Tax is the most important, the most beneficial, and the most sustainable source of finance for development. There is undoubtedly a role for foreign aid, but it can also foster rent-seeking by political elites and make rulers accountable to foreign donors, thereby undermining accountability to their populations. Moreover, aid is volatile, comes with strings attached, and can foster capital flight.

Perhaps most importantly, however, aid cannot match the revenue-raising potential of tax. Tax revenue in Africa, for example, is worth ten times the value of foreign aid. And in the longer term, low income countries must replace foreign aid dependency with tax self-reliance.

The role of taxation in fostering truly democratic and economically healthy countries is often summarized as ‘the 4 Rs of taxation’. The most obvious of these is revenue: to pay for health, roads, education and state responsibilities such as judicial systems and the rule of law. The second of the 4Rs is redistribution. Well-designed tax policies can redistribute wealth and income away from economic elites and towards more marginalized groups, thereby addressing inequality. In this regard, direct taxes on income, property and corporate profits tend to be progressive, while indirect taxes, such as VAT, tend to be regressive.

Taxation also plays a crucial role in repricing, altering the costs associated with certain goods and behaviours and thereby incentivizing or disincentivising them Carbon taxes, for example, could have a critical impact in tackling climate change if they are well-designed. Finally taxation is equally crucial to representation in democratic societies; it is well-documented that effective taxation fosters accountable and responsive states.

Taken together the 4Rs, and the extent to which they are effectively combined and implemented, can provide governments with the resources necessary to deliver economic development while also making sure that their societies are just, equal and democratic.