In recent years, tax exemptions for donor-financed projects have come to the fore within the international community. Interest has increased because of the need to improve domestic resource mobilisation (DRM). This has become all the more necessary following a series of recent development crises, which led to a predictable decrease in the volume of aid (it decreased by 3 per cent in 2011, according to OECD statistics).
Public development aid (PDA) contributes up to 30 per cent of budget resources in many developing countries, the need for aid increasing as these countries fail to mobilise sufficient domestic resources. Apart from providing budget support, project aid is a significant component of PDA.
Aid-funded projects often enjoy tax exemptions in recipient countries. These exemptions take various forms and are mainly for taxes like VAT, customs duties, excise duties, registration fees, etc. The policy of most donors is that the funds they allocate as PDA should not be used to pay taxes in beneficiary countries. As a result, tax revenue is forgone in these countries. In some countries, the tax revenue forgone is estimated to represent about 20 per cent of donor funding and/or imports.
Beyond the budget imbalances they cause, tax exemptions for aid-funded projects raise serious concerns about the performance of tax systems in developing countries. There are certainly some arguments for their reconsideration.
1. How tax exemptions affect the performance of tax systems
As mentioned above, the policy of donors is that the funds they allocate via PDA should not be used to pay taxes in recipient countries. From this perspective, granting tax exemptions to aid-financed projects is less of a political choice for recipient countries, and more a conditionality of aid. Of course, these exemptions can be considered as contributing to the public good. However, despite their economic and social benefits, they cause significant tax revenue to be forgone in beneficiary countries.
In theory, aid frees up government resources that can then be used to finance other projects. But, in practice, it supplements government investments and does not help achieve balanced budgets.
From the tax (administration and policy) perspective, the following problems arise from tax exemptions in general, and those granted to aid-funded projects in particular:
- more complex tax systems;
- additional management costs both for tax payers and tax administrations;
- important risks of tax fraud (deviation of destination), especially with respect to VAT;
- restrictions on the right to refunds affecting the neutrality of VAT.
In view of the above, there are several arguments that can be made for reviewing tax exemptions for aid-funded projects.
2. Arguments for taxing aid-funded projects
We have been seeing a change in donor policy for some years now. For example, on 13 April 2004, the World Bank allowed financing of reasonable, non-discriminatory tax costs. The main arguments for this are the rationalisation of tax systems in recipient countries, and the search for greater coherence in aid policy management.
With respect to rationalisation, problems derive from providing tax exemptions to aid-funded projects. Removing them could help to make tax systems simpler, reduce management costs, minimise the risk of tax fraud and strengthen the neutrality of VAT.
In terms of public financial management, it is agreed, especially by donors like the IMF and World Bank, that budget support is preferable to project aid when the recipient country is recognised as a good manager. Along the same line of reasoning, taxation of project aid is defensible because, in any case, all or part of the aid will go into state coffers.
Furthermore, with respect to aid policy, there should be agreement on development priorities between donors and recipient countries. The tax share of the aid can then be assumed to finance national priorities in terms of economic and social development (for example National Poverty Alleviation Programmes towards the achievement of Millenium Development Goals), as well as to ensure good public financial management.
In conclusion, non-taxation of aid-funded projects is a major handicap to improving DRM. This is why public authorities of developing countries and tax experts, in general, want to tax this type of aid.
At a time when there is a call to strengthen aid towards DRM (tax administration and policy), reviewing tax exemptions for aid-financed projects should be the first solution – and may be the best one – with respect to taxation.
- ATAF’s Parallel Session during the Fourth World High Level Forum on Aid Effectiveness, Busan, December 2012.