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Chapter 15

Finance and Fiscal Policy for Development

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Finance and fiscal policy for development

A financial system consists of:

• Central bank.• Commercial banks.• Savings and loans associations.• Mortgage institutions.• Credit and money markets.

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The Role of the financial system

1. Providing payment services:

• Inconvenient and risky to carry cash

• Financial system provides an alternative personal and commercialchecking and check clearing credit and debit cards.

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2. Matching savers and investors and allocating credit efficiently:

• Savers and investors must meet and agree on the terms of loans.

• Presence of credit markets (banks, venture capitalists, and stock markets) facilitates this matching.

• Optimal allocation of investment funds by channeling these resources to uses with highest expected rate of return.

The Role of the financial system

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3. Generating and distributing information:• stock and bond prices represent the average judgment of investors on expected profitability of a firm, based on publicly available information.

4. Pricing, pooling, and trading risk:• insurance markets and portfolio diversification provide protection against financial risks (i.e. F/X fluctuations, default on loans, etc.).

5. Increasing asset liquidity:• Easier to raise money through:

Selling your assets.Borrowing (against your assets) via bond / stock insurance.

The Role of the financial system

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The bumpy road to macroeconomic stability.

Macroeconomic stabilization has three objectives:

• Getting inflation under control.

• Restoring fiscal balance by reducing governmental spending raising government tax revenues.

• Eliminating the current account deficits by greater control on exchange rates export promotion.

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Two key agencies:

• International Monetary Fund in charge of international private lending.

• World Bank in charge of development assistance.

The bumpy road to macroeconomic stability.

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Differences between MDC and LDC financial systems.

In MDCs

• Financial intermediaries (central bank, savings banks, commercial banks, etc.) mobilize private savings and efficiently allocate them to most productive uses.

Central banks manipulate money supply to lower/raise the cost of borrowing for the private sector (i.e. households and businesses).

Loanable funds continuously flow in and out of highly organized and economically interdependent money and credit markets (with minimum government interference).

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In LDCs

• Banks ration limited funds to most creditworthy firms while other borrowers (i.e. small farmers, indigenous small-scale entrepreneurs and traders, etc.) seek financing elsewhere.

Money and credit markets are highly disorganized, spatially fragmented, and often externally dependent.

Commercial banking system lacks transparency (full disclosure of the quality of loan portfolios).

Differences between MDC and LDC financial systems.

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The Role of Central Banks

In MDCs

1. Issuer of currency and manager of foreign reserves, print money,distribute notes and coins, intervene in F/X markets.

2. Banker to the government.Provide bank deposit and borrowing facilities to the government.

3. Banker to domestic commercial banks provide bank deposit and borrowing facilities to the commercial banks and acts a lender of

last resort.

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In MDCs

4. Regulator of domestic financial institutions ensure that financial

institutions conduct business in accordance with laws and regulations.

5. Operator of monetary and credit policy manipulate monetary and credit policy instruments (i.e. money supply, discount rate, reserve requirements, etc.) to achieve macro objectives.

The Role of Central Banks

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In LDCs

LDC financial systems are characterized by:

• Foreign-owned commercial banks.• Informal and exploitive credit network.• A central bank that is neither independent nor effective.• Unskilled and inexperienced labor force.• High degree of political influence by government.

The Role of Central Banks

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In LDCs

Principal task is to attract domestic and foreign capital by generating a sense of confidence in the:

Credibility of local currency as a viable and stable unit of account.

Prudence and reliability of domestic financial system.

The Role of Central Banks

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The role of development banking in LDC industrial expansion.

Definition• Development banks are specialized public and private financial institutions that supply medium and long-term loans for creation / expansion of industrial enterprises.

How do they raise capital?1. Bilateral and multilateral loans from national aid agencies (i.e. USAID) or international donor agencies (i.e. World Bank).2. Loans from their own governments.

Industrial Project Appraisal• Direct managerial, entrepreneurial, and promotional involvement in the projects / enterprises they finance.

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Table 15.1: central banking institutions

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The bumpy road to macroeconomic stability.

Macroeconomic stabilization has three objectives:

• Getting inflation under control.

• Restoring fiscal balance.

• Eliminating the current account deficits.

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Fiscal Policy for Development

Stabilization Policy

• Monetary policy by central bank deals with:Money supply.Discount rate.Foreign reserves.Reserve requirements.

• Fiscal policy by government is concerned with:Taxation. Government spending.

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Table 15.2: comparative average levels of tax revenue (1985-1997), as a percentage of GDP.

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Taxation: Direct and Indirect

Direct Taxes:• Levied on private individuals (i.e. personal income tax), corporations (i.e. corporate income tax), and property (i.e. property tax).• Make up 30% of total tax revenues for LDCs.

Indirect Taxes• Levied on purchase, sales, or trade of commodities (i.e. sales taxes, import and export duties)• Largest source of public revenues (70%) for LDC governments.

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Table 15.2: comparative average levels of tax revenue (1985-1997), as a percentage of GDP

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Fiscal Policy for Development

Two purposes of taxation in LDCs:

1. Tax concessions and other fiscal incentives to stimulate private enterprise tax breaks to foreign investors to induce inflow of capital.

2. Mobilization of resources to finance public services, Health education, and transport services, legal, economic, and military

institutions, direct transfers to poor, etc.

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Taxation potential depends on:

1. Level of per capita real income2. Degree of inequality in income distribution3. Industrial structure of the economy and importance of different types of activity extent of foreign share in domestic private

enterprise4. Social, political, and institutional setting and relative power of different groups:

Landlords versus renting manufacturers.Manufacturers versus labor unions.

5. Administrative competence, honesty, and integrity.

Fiscal Policy for Development

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Direct Taxes on Income and Property

Personal Income Tax: percentage x of income.

• Yield lower revenues as fraction of GDP in LDCs.

• Progressive income tax system (people with higher incomes pay a larger percentage of their income in taxes) to raise revenues and lower income inequalities.

Property Taxes: $y depending on the value of property.

• Efficient way of correcting social inequalities in countries where the property ownership is heavily concentrated.

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Corporate Income Tax: percentage z of corporate profits.

Less than desired levels of revenue for LDC governments due to provision of tax incentives and concessions:

Long periods of tax exemption:Investment depreciation allowances (depreciation lowers taxable

profits). Special tax write-offs.

Direct Taxes on Income and Property

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Indirect Taxes on Commodities

Import Duty (tariff): percentage t of sales price of imported commodity:

Commodity tax revenues (import / export duties and excise taxes) are the largest source of public revenues for LDC governments:

Are easy to assess and collect:Don’t rely on individual reporting like personal / corporate income

taxes are charged at the time/location of transaction.

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Table 15.4: Trends in global military spending

(1960–2000) (billions of U.S. dollars).

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Table 15.5 World Military Expenditures, (1994–2003) (billions of 2000 U.S. dollars)

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Table 15.6: Military and social expenditures in developing and industrial countries (1995)

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Table 15.7: countries with the highest and lowest expenditures on the military (2002) (percentage of GDP)

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Table 15.7: countries with the highest and lowest expenditures on the military (2002) (percentage of GDP)