Taxation System Fiscal Governance And Resource Mobilization

Published Date: 02 Nov 2017

This chapter focuses on the historical and theoretical models and relationship of taxation with the influx of foreign assistance. This is achieved by reviewing a variety of academic books and renowned journal articles, getting a sound know-how of the theories pertaining to taxation systems, governance and foreign aid and then studying them thoroughly by comparing and contrasting different case studies of countries globally. A great insight into the issues of the variables under scrutiny are connected and related with the overall theme of this study and thrown light upon elaborately.

2.1 Taxation system, Fiscal governance and resource mobilization

This section analyzes the interplay of the taxation system, fiscal governance and the mobilization of resources across countries, with a special emphasis on the historical overview of taxation reforms and structure, its effectiveness as seen through the lens of various international models of tax effort, the role of the public sector in addressing the loopholes in taxation structures worldwide using well-assessed indicators of tax effort.

2.1.1 Taxation structure: international historical overview

Historically, the structure of taxation has been seen and analyzed under the groups of direct and indirect taxation. Most developing countries have relied a great deal on indirect taxation, mainly on consumption and other indirect taxes since it is easier to tax consumption than to tax income- a direct means of taxation (Ahmed et al, 2008). In lieu of this, numerous developing countries have opted for excise taxes and tariffs.

On the other hand, indirect taxation such as the Value Added Tax (VAT) has never been so easy to implement for the developing countries. Ehtesham Ahmed and Nicholas Stern of the prestigious London School of Economics and Political Science have done a great deal of research over tax issues pertaining to the VAT. Typically, VAT was implemented in the form of Gross Sales Tax in many countries since it was easier to supervise and monitor it within the given administrative expenses. Moreover, with VAT, the coverage of collection is more extensive as compared to income tax because VAT takes care of the shadow economy as well.

Burgess and Stern (1993) came up with quite a few interesting facts pertaining to taxation. According to them, developing countries, in comparison to advanced countries, have the tendency to rely more on non-tax revenues and obtain a high share of their total tax revenue from indirect taxes, chiefly international trade taxes and domestic taxes on goods and services, as compared to direct taxes such as taxes on income and property (Mahdavi, 2008).

The structure of taxation in a typical developing country such as Pakistan is, characterized by direct taxes which are not complied with effectively and indirect taxes which are mainly paid by those who are otherwise underprivileged enough to pay taxes, and exemptions being taken up by those who are not in a position to receive them. The drawbacks for such countries of taxing income include high administrative costs, tax evasion and disobedience to the regulatory law. Other than this, income tax collection has generally been lower in developing countries due to lower income levels where collection at higher marginal tax rate has been minuscule.

2.1.1.1 Effectiveness of taxation structure: a cross country analysis

Mahdavi (2008) studied the structure and composition of taxes over a panel data of countries. The composition of tax structure and its effect on the process of economic development is crucial for many reasons. First, a stated threshold of taxation can be related to various diverse tax revenue compositions across countries and time. Although the threshold of taxation is taken as suitable, its combination may not essentially be "advantageous" to the degree that the system of taxes exploits some tax categories and underuse some other ones (2008). Second, possible determinants of the stage and level of tax revenues are expected to have diverse implications on various compositions of total tax revenue. An critical know-how of the way an alteration in a specific determinant shifts the tax revenue composition is vital in structuring policies to better develop the tax revenue blend. Third, various types of taxes may diverge in relation to their effects on "labor–leisure and saving–consumption choices, administrative and compliance costs, the scope for evasion and avoidance, simplicity and transparency, stability, and elasticity with respect to economic growth" (Mahdavi, 2008). Similarly, at any threshold of tax revenues, an alteration in the constituents of tax revenue may also have unusual inferences in relation to growth in output, reliability and revenue stability pertaining to the category of tax that formed the basis of the adjustment. Lastly, throwing a spotlight on the behavior and performance of the level of tax may cover the required data or information relating to the viability of sporadic revenues from one kind of tax for losses in revenue for another. Astoundingly, the empirical learning of the blend of tax revenue in developing nations are generally limited to the explanation of the divergence in the tax revenues structure among developing countries and industrialized countries.

2.1.2. Tax Administration impacting Tax Effort

A proxy indicator for tax administration is the number of tax payers in the country, which remains significantly low in developing countries, such as Pakistan. As a developing country, Pakistan is of striking importance for its slackening quality of tax administration. Low growth in the number of income tax payers, which remained at approximately two million in a nation of 180 million people, is another crucial reason why the country held a stagnant tax-to-GDP ratio for the last decade, or even more. Also, from about 17000 existing enterprises in Pakistan, only 4000 officially declare taxable income. Statistics reveal a astonishing fact that more than a 100 million cell phone users in Pakistan pay a 10 percent income tax as a rule, but a majority does not file tax returns. Owing to the fact that a lot of tax evasion happens as a result of the rich being outside the tax net or failing to pay income taxes, poverty deepens in society. The poor are overburdened with taxes- mainly including a 16 percent sales tax on the items of consumption as well as being subjected to withholding taxes at source below the income bracket of Rs, 350,000 (Ghaus Pasha, 2010).

2.1.2.1 Role of the Government to increase Tax Effort

There are several drawbacks of taxing income for developing nations, including elevated administrative costs, tax evasion and noncompliance with the regulatory law. Other than this, income tax collection has usually been on the lower end in developing countries due to low income levels where collection at higher marginal tax rate has been very small. Theoretically speaking, a more progressive tax system should lead to the lessening of the extent of tax evasion. Governments have been participating in efforts to increase tax effort. In a typical developing country, such as Pakistan, the government introduced a universal self-assessment scheme (USAS) in the 1990s which, unfortunately, was not accompanied by a fair audit process. This very scheme took tax collections on demand after the audit process, approximating over 20 percent of total tax revenues, which fell drastically to a 10 percent in 2004-05 (Ghaus-Pasha, 2010). Corruption is deepening in the Pakistani society day by day and is a major root cause of a low and almost non-existent tax effort. The People’s Party government under the leadership of Mr. Asif Zardari, has recently announced the cancellation of National Identity Cards (NICs) of those citizens who have not registered or declared their incomes officially to the Federal Bureau of Revenue (FBR) and do not currently hold a National Tax Number (NTN). Such efforts on the part of the government will produce results with a huge time lag and its efficiency might be put under question.

The way forward in order to improve tax revenue collection and management is the government’s implementation of a proper resource mobilization plan in any nation of the world, which should have various aspects to address such as the development of the existing General Sales Tax (GST) to cover the exempted sectors of the economy, typically in the developing world; improvement in the regional tax- to-GDP ratio by improved quality and potential of tax administration and considerably less prospects of tax evasion and expansion of direct tax or the income tax administration. These changes will lay the path into bringing any country out of low tax revenue trap. However, the political will of the country’s leadership is a critical factor in order to bring further improvements in tax administration, adjustment and implementation of sound rational tax policies and the promotion of higher tax compliance by the citizens of countries.

Deborah Brautigam (2009) consolidates the political economy theories of taxation, which stress on elite dominance and ethnic division and would very well be useful in explaining why growth in developing countries cannot be translated into development and higher tax revenues. Let’s take the case of Pakistan, again, for reference. The rural areas of Pakistan are notorious for being dominated by large ‘feudal’ landowners. Such landowners have been outstanding and influential in almost all Pakistani government coalitions is a rationale as to why fiscal efforts have been resisted, especially in agriculture. Their power and influence was so immense that they were able to obstruct direct taxation of agricultural income for long, unjustly depriving the country of a major revenue supply. These landowners had formed a coalition with the military leadership under the Musharraf regime (1999-2008), too, and have over time played an important role in Pakistani politics.

Moreover, the economists and academics within the governments may also resort to econometric modeling and other mathematical techniques over the national data to ensure tax compliance. Using new technique of data mining over a panel of countries, Wue et al (2012) build up a test structure to sieve the probable non-compliant reports on the VAT that can be made the subject to additional inspection. The projected data mining method, as the results imply, improves the uncovering of tax evasion, and could be engaged with to successfully minimize tax revenue losses from Value Added Tax evasion.

A crucial effort on the part of the public sector, again, is required when it comes to bringing large underground economies to documentation within the developing world. With the expansion of informal sector in the developing economies and government's futile efforts to increase the revenue collection from this very sector, the importance of taxing informal sector has become even more crucial. Various advisory and regulatory organizations have stressed to focus on the tax payers in the formal sectors, with the expectation that VAT or other indirect taxes will eventually swallow up the informal sector (Tanzi and Zee, 2001). Nevertheless, the importance of taxing informal sector should remain the core of the tax system to avoid the formal sector bearing the brunt of tax regime individually and to increase the accountability in relationship with taxation for a sound, healthy economy.

The most apparent reason as to why it is difficult to tax informal sector is the nature of the sector itself. Informal sector has a multifaceted structure with large number of diverse operators involved in it. Most businesses are carried out at homes which remain undocumented and difficult for the authorities to keep an eye on. Moreover, lack of illiteracy means less trust in banks and more hard cash dealings. Amidst these grave issues, the government finds it cost-ineffective to allocate the essential resources for taxing informal sector. Not only this, some countries do not have the capacity or the resources to carry out thriving revenue collection in this sector (Joshi and Ayee, 2008). Furthermore, in places with feudalism, especially in South Asia, and parallel government structures, in African Countries for example, where many non-state actors exist, the incentive to tax informal sector is even lower. Tax officials find it unrewarding and sometimes life-threatening to carry out their activities in these circumstances. Hence, it is safe to say that taxation involving the underground economy is very challenging, and so is dismal on the part of many developing countries, such as Bangladesh, to lack a hike in annual tax revenues, which would otherwise have been possible.

2.1.3. International Tax Effort Models

Tax effort models have been viewed as providing a policy maker with a normative, somewhat monotonous, prescription concerning the appropriateness of a country’s tax rate. So to say, the tax effort model has been used to suggest whether a specific country has a low or a high tax capacity and tax effort, relative to other countries (Clyde Taylor, 1979). In a tax effort model, it is important to explain only those variations in the share of taxes which are due to taxable capacity factors in a multiple regression equation. The few main models include the Lorz and Morss Model, The UNCTAD model, the Bahl model and the Fiscal Decision Maker model of tax effort.

2.1.3.1 Lorz and Morss model

The Lorz and Morss tax effort model (1967) represent an addition of state and local tax effort models to cross-country comparisons. It attempts to explain those factors measuring a country’s taxable capacity in order to determine a country’s tax effort.

2.1.3.2 UNCTAD model

The United Nations Conference on Trade and Development (UNCTAD) model (1970) differed from the Lotz and Morss model in that it took pooled data by using cross-section and time series data together. A crucial assumption made was that those factors which determine taxable capacity cross-sectionally also determine taxable capacity over time.

2.1.3.3 Bahl Model

The Bahl model (1971) summarized many of the previous tax effort models, examined their differences and came up with a tax effort model that dealt with some of the main methodological and theoretical problems related with the tax effort approach. Bahl noted that three main determinants of tax effort are the crucial ones: the relative productivity of public versus private investments; a desire of the government to intervene in the resource allocation procedure for distributional reasons; and historical institutional arrangements for particular activities between public and private sectors. The three variables measuring taxable capacity in his model are the stage of development, size of the foreign-trade sector, and a measure of the sectoral composition of value added.

2.1.3.4 Fiscal decision maker model

In the fiscal decision maker model, the concept of a country’s taxable capacity is the tax share generated by the general adaptation of fiscal decision makers to expected changes in the socioeconomic environment in which they act. Tax effort is envisaged as deriving from specific country differences in the socioeconomic environment to which the fiscal decision maker can adapt to some degree. Political survival as his primary goal, the fiscal decision maker chooses the taxes and social good expenditures that enhance the probability of his reelection or reappointment. In this new tax effort model, the level of development variable becomes a proxy for the network of changes in tax resistance while the openness variable becomes a proxy for the cost of tax administration. So, tax effort is determined by the willingness of the fiscal decision maker to utilize taxable capacity.

2.1.4 Indicators and instruments of assessing tax effort

‘Tax effort’ is the ratio of the split of the actual tax collection to GDP and the anticipated taxable capacity of a country. A high tax effort value (of approximately above 1.0) shows that the country exploits its tax base well to add to revenues (Stotsky, et al. 1997). On the contrary, tax effort below 1.0, is expected to have comparatively significant potential to boost revenues. The notions of tax effort and taxable capacity can be further used to calculate the capacity of fiscal revenue and similarly, effort in fiscal revenue. Capacity of fiscal revenue comprises of both non-tax and tax collection; it shows the impact of cash proceeds from nontax and tax sources such as fees, and income from property or from the foreign trade industry. Choosing the method used to approximate and construe the tax effort index is a point of caution. The computation of the index is very receptive to the expected outcomes of a nation’s taxable capacity (Minh Le et al, 2008).

Stotsky and WoldeMariam (1997) examined tax-to-GDP ratio as a proxy for tax effort, which is calculated as the total tax collection by the government as a proportion of the nation’s GDP. The actual tax to Gross Domestic Product ratio is typically analyzed to gauge tax effort and used in relation to cross country tax assessments. Usage of such ratio seems sensible if attempted to generate trends or contrast tax revenue capacity and effort across countries with comparable fiscal structure and income. A benefit of applying this method is that it is easy and gives a quick impression of the general trends of the tax collections internationally. However, when it is used to evaluate the efficacy in the mobilization of tax revenues across countries in various groups of income, tax-to-GDP ratio has the tendency to show a convoluted view because of the various fiscal structures, demographic trends and institutions of the countries (Prest, 1979). In such circumstances, this ratio fails to mirror the tax potential or capacity of a nation, making it an unfeasible task to review whether or not a country is an outlier in assessment with its so-called peers in its attempt to increase domestic tax revenues.

Tax base availability, which is an interpretation of tax capacity again, shows the predicted tax-to-GDP ratio projected from regression analyses, while accounting for an economy’s precise characteristics. These have been indicators in literature for tax effort that the four models previously discussed above have been used for further analysis. Every model uses its own different definition of taxable capacity and the economic assumptions that come with it. Traditionally, indictors of development were used to measure tax effort. For example, in the later Fiscal Decision-Maker model, tax effort is determined by the willingness of the fiscal decision of the fiscal decision maker to maximize taxable capacity (Clyde Taylor, 1979). The different approaches chosen by Lotz and Morss, Bahl and the later tax effort models can be seen as deriving from their varying buoyancy showing that there exists a pattern of development in relation to tax structure for least developed countries.

Chelliah et al. (1975) highlights the fact that tax effort measures are not only and solely meant to be made functional in a theoretical manner; they should be taken as important supplementary information in analyzing the capacity and range for additional taxes. Tax effort as a variable cannot serve as a replacement for a wide-ranging study of taxation when it comes to the requirement and status of state expenditures of any country.

2.2 Foreign Aid in Perspective: A Cross-Country Analysis

This section particularly focuses on foreign aid itself and the various perspectives associated with it globally. A cross country analysis is provided pertaining to the measurement, evolution, nature and sources of foreign aid influx. The diverse theories and models of foreign aid in literature further provide an overall view of the concept of foreign aid and how it is determined.

2.2.1 Defining and Measuring Foreign Aid

Foreign aid and private investment from abroad are two of the significant sources of capital for the developing world. For simplicity, foreign aid can be categorized into low interest loans and grants. The last three decades have observed important changes in the trend of such foreign capital flows from the developed to developing countries. Foreign aid has been seen to rise from US$1.9 billion in 1970 to US$27.1 billion by the late 1990s for the developing nations (Ghaus Pasha, 2010).

Source: Hang Le, Ataullah, 2006

2.2.2 Evolution of Foreign Aid

Foreign aid has been a vital source of overseas capital during the period 1960s to 1980s for developing nations. Initially, being an important economic bloc, the USA strategically started its first foreign aid program in the earlier years of the Cold War. It established the country's supposition of their new political and economic role, as represented in the Truman Doctrine and its way of supporting the earlier British patrons such as Turkey and Greece. Foreign aid was also used by the U.S.A to give rise to free-market policies for economic development, the amalgamation of West European nations and the restriction of protectionism, using instruments such as the Marshall Plan. It was thought that these programs would significantly give an advantage to the U.S.A economy as it would be able to give orders at home. Even more importantly, these efforts were intended to thwart the increase of communism, since by 1946 the U.S. state policymakers started becoming increasingly persuaded that the Soviet Union was aiming towards word domination.

For many African and Asian economies, the source of money flowing in as foreign aid was a vital basis of capital for long. Particularly during the 1960s and 1970s, Pakistan was seen as one of the major foreign aid recipients within Asia and Asia Pacific. In the 1980s, Pakistan received a great deal of foreign aid in lieu of its forefront role in the Russian- American clash over its bordering country, Afghanistan. Such foreign aid flows touched US$2 billion annually by 1985 and are asserted to have enhanced the inadequate domestic savings and foreign remittances, and increased the credit praiseworthiness of Pakistan (Husain, 1999).

The lessening of the strategic importance of foreign aid has been reinforced by the end of the Cold War which led to its decreasing flows in the 1990s. Though the quantity of aid has decreased significantly, the amount of aid agencies has been seen to shoot up from approximately 7 in 1960 to around 50 by the 1990s. The multilateral institutions, most importantly being the World Bank and the International Monetary Fund have taken a somewhat distinguished right over the fiscal policies of the developing world. These organizations enforce firm circumstances on the beneficiary countries and intimidate them to withdraw aid if the states of affairs promised to them are not fulfilled. To some degree, aid flows have encouraged growth and structural change in the beneficiary countries, particularly in the period of natural calamities and post-war reconstruction. However, it is explicitly stated that the implications of foreign aid on growth and expansion are inadequate since foreign aid is frequently aimed at political and military fields in contrast to human development (Hang Le and Ataullah, 2007).

2.2.3 Types and nature of foreign aid

Foreign aid has an extremely diverse and heterogeneous nature. We cannot give a single figure to it and analyze the whole situation based on just one figure (Mavrotas, 2002).

2.2.3.1 Sources of foreign aid

Quite a few types of foreign aid are presented in literature. Some are as follows: project aid with a long development time period, food aid, technical support aid, and various other kinds of product aid. To these different categories of foreign aid, relief or emergency aid is an addition as a distinct category, observing its rising significance in current times (Mavrotas, 2002).

2.2.4 Theories and Models of Foreign Aid in Literature

This sub-section highlights and discusses the theories and models of foreign aid which are widely presented and debated within literature. The dual gap model and the foreign exchange model provide further insights into the behavior and nature of foreign aid and its changing pros and cons over time.

2.2.4.1. The dual gap model

A theoretical model of foreign aid in literature is the dual gap model. The Dual-gap theory stresses the function of foreign exchange and imports within the process of development. The characteristic connection of the dual-gap examination is that even though foreign exchange comes up as the leading restraint, it highlights to the double function of overseas borrowing in increasing already scarce foreign exchange and in domestic saving. It is evident that provision of services and good at home requires domestic saving; and vice versa. A need for a least amount of overseas earnings as foreign exchange to maintain the process of growth is required. The model takes both traditional and modern view on foreign aid- as enhancing domestic saving and, while on the contrary, import of goods necessary for growth with the aid of foreign assistance. The dual-gap analysis thus reflects an even more pertinent theory of trade for the developing world which validates and rationalizes import substitution and protection (Ahmed, 2001).

2.2.4.2 The foreign exchange gap

The foreign exchange gap is defined as the shortfall on the nation’s current account where the balance of payments exceeds the resource inflows. The foreign exchange gap is a concept very pertinent to developing countries. They are usually characterized as being short of capital, since their saving and investment rates differ from developed nations. With external aid along with diverse categories of monetary help, developing and underdeveloped countries can get initial capital required to embark on the pathway to industrialization. Once industrialization is underway, the problem of domestic saving resolves gradually. The two gap model is based on the assumption that for developing countries to maintain high growth and industrialization, foreign currency is needed to import capital equipment, raw materials and intermediate goods. Thus foreign exchange gap can become a big development constraint.

Hence, recipient countries may require foreign aid in order to cater to their foreign exchange gap.

2.3 A Review of the Demand and Supply Side Factors of Foreign Aid

This section has its own importance in understanding the reasons why some countries are more interested than others in receiving and giving aid. The political economy of foreign assistance is considered here and the crucial motives of both parties in the equation – the demand and the supply side- are discussed and analyzed in great detail. The geopolitics of foreign aid is of deep concern to policymakers and economists and will be shed light upon in the later half of the section.

2.3.1. Demand side factors and the three gap model

As opposed to full-employment macroeconomic models of growth, the three-gap model unambiguously looks at the interplay between "capacity expansion and capacity utilization" (Zhang and Chen, 2006). In addition, less data prerequisite of this particular model makes it compatible for usage to countries such as China and Pakistan, where it is seem that the reporting, coverage and accessibility of data over time is very restricted. Gap analysis supposes that the marginal capital-output ratio, along with other behavioral indicators, is fixed within the medium-term. There is restricted replacement and substitution between domestic and foreign resources.

According to the three-gap model, expansion and utilization of current productive ability is inhibited by the foreign and domestic savings and also by the great impact of monetary restriction on government spending, hence limiting the investment choices in the public sector (Zhang and Chen, 2006).

2.3.1.1 Motives of Recipient Countries of Foreign Aid

Many beneficiaries obtain aid from some OECD benefactors annually. Recent research suggests that corrupt recipient governments, especially of the developing world, have incentives to fulfill objectives of the donors in the public health sectors but they have an opportunity to follow this in aid sectors, where observance is less costly. This particular policy plan allows dishonest recipients to achieve specific developmental missions successfully, hence providing an explanation for supplementary aid flows into their country (Dietrich, 2011).

2.3.1.2 Policies of recipient countries regarding foreign aid

Many developing nations experience a phenomenal debt burden in lieu of the growing tendency towards giving loan aid as opposed to giving aid as grants while tying the aid flows to the donor countries’ exports. Given the ambiguous results of foreign assistance and inadequate power over the quantity of aid received, practitioners and policy makers in developing nations make an effort to seek substitute basis for overseas capital, such as foreign private investment and direct and portfolio investment.

Also, the conditions imposed by aid agencies such as IMF and World Bank, may lead to limitations on policy autonomy of the recipient country and become influential in dictating governments of recipient countries. Observed evidence recommends that aid has not added intensely to the growth and economic development of beneficiary countries and in many cases it has amplified disparities among diverse groups or classes (Hang Le and Ataullah, 2011). Many studies even suggest that aid has the potential to delay the timing of important improvements and changes by giving supplementary capital to vested benefits which persuade the establishment of the recipient country to refuse to accept adjustments (Casella and Eichengreen, 1996).

2.3.2. Supply Side Factors of Foreign Aid

This sub-section looks into the motives and determinants of the donor countries and other multilateral organizations in formulating aid policy. Their strategic interests in the matter politically and economically are highlighted in great detail as one reads on.

2.3.2.1 Determinants of donor’s aid allocation policies

The mounting propensity toward giving aid in the form of loans as opposed to giving aid in grants and towards fixing aid to the donor countries exports is a way of the donor to increase the debt burden of the recipient country so that it becomes economically dependent on it for servicing its debt (Le and Ataullah, 2011). Foreign Aid institutions, such as WB and IMF, have become even more dominant in using the governments of recipient country in their own strategic interests.

Bermeo (2011) studies data to investigate the relationship between aid flows and the possibility of that aid leads to democratization within aid recipients. According to him, the association of democratization and foreign aid lies on individuality of the aid benefactor. In the period 1992 to 2007, aid from democratic donors was observed to be linked with an addition to the likelihood of a democratic changeover. It suggested that self-governing and independent donors use limited aid capital to support democracy. However, within the same phase, foreign assistance from authoritarian governments shows an inverse relationship with democratization. Authoritarian donors are doubtful to embrace democracy endorsement in their purpose to determine the policy of aid. China, for example, puts small conditionality on the aid it extends and does not prioritize democratization.

Exploring the websites for some famous development aid donors, such as the Abu Dhabi Fund for Development, the Saudi Fund for Development, and the Kuwait Fund for Arab Economic Development substantiates that problems of governance are not big priorities for these donors. The Saudi Fund clearly puts its stance forward that loans it makes are without any stipulations and that it has direct deals with departments under the federal government of developing nations in sponsoring developments projects, providing direct confirmation that it does not follow new ways of directing aid which many OECD donors comply with. It is possible that the difference seen in the contrast between democratic and authoritarian aid is in their association with regime change and is driven by the choice of recipients to a great extent.

Balla and Reinhardt (2008) have another viewpoint. They find that donors have frequently reacted to stable and balanced incentives to decrease poverty in the recipient country and project donor economic and socio-political goals. Almost every bilateral donor likes to base the provision of aid over conflict. The U.S. proportions huge quantities of aid in development to those specific countries which are bordering a conflict, in pre-Cold War and even post-Cold War eras. However, taking into consideration the level of development and the political and socio-economic interest of the donor countries, "most donors reduce aid to a recipient with an in-house or nearby intense conflict" (Balla and Reinhardt, 2008).

It is seen that most western donors extend considerable quantities of foreign aid towards corrupt recipient countries. It generally refers to failure in policy, but for many it is pinpointing practices of donors that goes unnoticed in prose: the governments of recipient countries’ exceptional performance within foreign aid sectors, despite the pitiable national institutions present, has a big say in aid allocation for donors. "When evaluating the high fiduciary risks associated with spending money on the world’s poorest and often most corrupt countries, donors look for specific sector-related progress" (Dietrich, 2011).

2.3.3 Politics and Geopolitics of Foreign Aid

This sub-section sheds light upon the strategic interests of both the recipient and donor countries and institutions as part of the global arena and how this relates to policy-making by these bodies which not only affects worldwide agenda and politics but also the scheme of things at the regional and local levels, too.

2.3.3.1 Geopolitics and foreign policy

Quite a few donors in democratic aid state the promotion of democracy as a major goal in their foreign policy. The United States Agency for International Development (USAID) puts forward the view the view that their work gives support to evenhanded economic growth while extending U.S foreign policy motives by helping in sustaining growth, trade, agriculture, democracy, humanitarian assistance, global health and conflict deterrence.

The United Kingdom’s Department for International Development (DFID), however, gave shape to Governance and Transparency Fund which redresses issues which enable citizens of nations to voices their views and holds their governments accountable to their actions (Bermeo, 2011).

2.3.3.2 Geopolitics and foreign aid

Tingley (2009) uses a cross-sectional data set over a period of time to examine the power of alterations in fiscal and political variables. According to him, as governments move to being traditionalists, their aid endeavor starts to fall. Political variables domestically emerge to sway aid effort. However, foreign aid to countries with low-incomes as compared to middle-income countries which remains unaltered. This emphasizes donor fiscal and global planned interests as reasons of aid policy of donors may be misjudged. His results advocate foundations of aid unpredictability that could pressure recipient prediction of growth (2009).

2.3.3.3 Governance and its relation to foreign aid

Burnside and Dollar’s (2000) study introduces the role of governance and power into the debate on the effectiveness of aid. They analyze the fact that aid adds to overall economic growth in the recipient country, provided it is used optimally with good governance practices and fiscal and monetary policies. They shift the focal point towards institutions, finding evidence for a multiplier outcome of good and sound governance.

The focus of researching the efficacy and effectiveness of aid is the breaking in result of political institutions. Kosack (2003) looks into the consequence of democracy but adds the aspect of human development to it too. He finds that the more democratic a government is, the more likely it is to be more proficient at directing aid by bringing sound changes to peoples’ lives, as calculated through the Human Development Index (Dietrich, 2011).

Recent research suggests that corrupt recipient governments, especially of the developing world, have motivation to fulfill objectives of donors in the public health sectors but they have an opportunity to follow this in aid sectors, where observance is less costly. This particular policy plan allows dishonest recipients to achieve specific developmental missions successfully, hence providing an explanation for supplementary aid flows into their country (Dietrich, 2011). This implies huge loopholes in good governance by recipient countries.

There are examples that state otherwise. Good governance practices can be found in corrupt recipient countries too. Bangladesh, a South-Asian nation has been entitled US$ 833 million in aid in the year 2006, in which US$ 170 million was put into health-related projects. Despite extremely high corruption levels and being ranked as being one of the most corrupt countries globally, the country has revealed notable success in the last couple of years in moving towards the betterment of the prior condition of basic health services. Representatives from the donor agencies appreciate Bangladeshi collaboration in tackling essential needs of their citizens, particularly on child health outcomes. An effect on the nature and size of foreign aid is directly proportional to how the recipient countries have previously responded to such inflows in their economies with regards to donor conditionality.

Similarly, Mali, which is also seen as a corrupt country, has received a positive feedback by an OECD health aid assessment (2009) however; it succeeded very little in otherwise. It has proved itself in a lot of other projects that have been a imperative to its society for long: targeted and sustained immunization, nationwide campaigns on the knowledge and understanding on the treatment of diarrhea and pneumonia and improving sanitation have been a success story for Mali. Theories on the effectiveness of aid, which have usually paid more attention to the value of governance, find such success stories as inconsistent. Such scores of corruption clearly show that the Bangladeshi government seems to be directing substantial quantities of public aid in health for personal motives and less for development reasons (Dietrich, 2011).

There is mounting harmony over the fact that transparency in aid and good governance must be made better by the day to obtain effectiveness in aid projects. Aid transparency can be defined as complete accessibility of aid information in a systematic and timely manner, which would allow community contribution and membership in government accountability (Ghosh and Kharas, 2011). Greater transparency in recipient countries always provides a useful way for donors to interpret and analyze their aid programs more efficiently.

The United States and a few other donor countries make aid available through numerous agencies, many a times with common responsibilities. The consequence is a convoluted replication of behavior and actions which diffuses accountability.

"Greater transparency is necessary for recipient country citizens to be able to hold their government accountable over discrepancies in the figures for foreign aid spent and received. For example, in Afghanistan, an official at the Ministry of Finance when interviewed by Oxfam America said that since 2001, the US had pledged $32 billion in aid but less than 20% ($6 billion) was recorded in the government databases. This means that Afghans have no way of knowing what happened to the other $26 billion that the US could have spent in their country. With greater transparency of how much aid is coming into their country, citizens and government officials can have a greater say in how best to use the funds" (Ghosh and Kharas, 2011).

2.4 Foreign Aid Inflow, Tax Reforms and Tax Effort

This section analyses the unique relationship of tax effort with foreign aid flows. Aid effectiveness on tax effort, the composition of aid and tax effort and the impact on foreign assistance on tax revenue and tax effort are highlighted with the help and support of various case studies.

2.4.1 Aid effectiveness on tax effort

The relationship between aid effectiveness and tax effort can be highlighted using the case of Pakistan as a typical developing nation. Pakistan was among the major aid beneficiary countries in the 1960s, 70s, and 80s. Unfortunately, the benefits of such aid could not reach the society as a whole, especially in areas of fiscal revenues. Foreign aid failed to induce the government to develop a sound education standard for the country. Though Pakistan had a great influx of aid within this time period, the enrollment rate in schools of children- and the overall illiteracy rate- continued to being at its former level (approximately 59-65%). Other Asian countries such as Malaysia and Sri Lanka which got only a partial share of aid comparative to Pakistan in the 1970s were successful in improving the literacy rates significantly. Other indicators, like employment and health, present the same depiction.

2.4.2 Composition of aid and tax effort

The composition of aid and tax effort can be clearly related through the example of Pakistan. The U.S.A has been Pakistan’s biggest donor of economic and military aid. Hence for simplicity purposes, the figures for U.S aid will be considered in the analysis. Official figures reveal that for more than half a century in Pakistan’s life, the U.S.A has given Pakistan a sum of USD 33 billion in fiscal and USD 9 billion in military aid. For the 32 years of military regimes that the country has had, Pakistan received a total of USD 25 billion in economic aid and USD 6 billion in military assistance. This is in contrast with the democratic regimes, where US aid under these sub-categories summed up to USD 9 billion approximately and USD 2 billion, respectively (Ali, 2009).

A snapshot of the military and economic assistance from the US to Pakistan under the period of research is presented in the graph below where we can clearly see the sharply rising trend of military aid in relation to economic aid.

2.4.3 Foreign aid and its impact on tax revenue and tax effort

‘Foreign aid’ is taken here as both the official and unofficial loans and grants given to the country by various bilateral and multilateral sources. It is claimed that spending of the government and its revenue efforts are influenced by foreign assistance which are channeled through a reallocation in the broad groups of public income and expenditure (Ahmed et al, 2009). The generally accepted impression is that foreign aid will reduce revenues from taxation in the recipient country (Sharif and Munir, 2010). The rise in foreign aid inflow embarks developing countries on the path of complacency. This was the case of the military regimes of the country especially, where the fear of political reactions from citizens, influential bureaucrats and cronies barred them from decisions on domestic resource mobilization.

In economic development and political economy theory, we see that the governments which are hugely reliant upon ‘earned’ revenues, for instance taxes, in contrast to frequent ‘unearned’ revenues such as mineral wealth or foreign resource flows, are highly likely to be receptive and accountable to their populace. Vice versa also hold true; citizens who pay taxes are more demanding of responsive governments (Joshi and Ayee, 2008).