Financing development goals in times of crisis

Pursuing the global development agenda will require genuine commitment from political leaders and significant stepping-up of government efforts. But, above all, it will require increased financial resources. Where will these resources come from?

We are at the mid-point of the 2030 Agenda for Sustainable Development and governments are grappling with multiple crises, the most evident of these being the economic aftermath of the COVID-19 pandemic, climate change and the ongoing conflicts in Ukraine and Palestine.

Nobody can precisely quantify the crises’ net effects or predict when they will end, but almost everyone agrees that they represent significant headwinds for the global development agenda. According to the 2022 Sustainable Development Goals Report by the UN, progress on many targets may be slowing or even reversing as a result of the crises.

The challenge of financing the Sustainable Development Goals

The 2023 OECD outlook on financing the SDGs estimates that the COVID-19 pandemic has caused a decrease in nearly all sources of finance for development, amounting to a 17% drop over 2019-2020. This leaves the poorest countries with an increasing shortfall.

Foreign aid is, and will likely remain, an important source of development finance. However, these are not normal times for development cooperation. Official Development Assistance (ODA) was at record levels in 2020 and 2021, but only due to COVID-19 related expenses. Apart from that, contributions have been stagnant over the last few years, and there is no increase in sight as rising military spending in Europe most probably diverts resources away from development aid.

Normally, loans provide an alternative to foreign aid for poorer countries.  But rising interest rates, high debt loads, and uncertainty in capital markets make borrowing more costly. The ‘polycrisis’ means that resorting to debt may not be a good option now for many Global South countries. Indeed, the world may be facing a new debt crisis, with a high likelihood of painful fiscal adjustments and reduced fiscal space – in other words, policies that add up to austerity.

Taxation matters, but how do states learn to tax?

With foreign aid and borrowing becoming less prominent, what other finance options do less developed countries have to drive their development? Taxation is key. It is a fundamental part of how states provide crucial public goods and services that support development, such as universal education, public health systems, and an effective administration of justice.

Improving the ability of developing countries to generate resources for development spending is now part of SDG 17: Partnerships for the goals, where Target 17.1 requires ‘strengthening domestic resource mobilization’. Progress on this target is measured by ‘Total government revenue as a proportion of GDP’ and the ‘Proportion of domestic budget funded by taxes’.

This choice of target and indicators may turn out to be a particularly timely one, not only because the SDGs agenda is much more ambitious than that of the previous Millennium Development Goals (MDGs). In the current climate, where development financing faces new headwinds, governments may have to increasingly focus on domestic revenues and, in particular, tax revenues.

This is not without challenges. With stagnant or declining economic activity, tax revenues may decline too. To address this, tax policies may have to be adjusted. For example, the OECD finds that significant resources may come from “stopping the leaks” by recalibrating tax breaks on aid. Similarly, a significant amount of tax revenues may be recovered with a crackdown on tax havens. This would no doubt help.

One, however, should also reflect on the capabilities of states to tax. Improvements on this front, by building fiscal capacity, may have long-lasting effects that stretch well beyond the development goals cycle. But how do states learn to tax? The formation and organizational performance of public finance institutions, and national revenue administrations in particular, depends on a number of structural factors, including the economic and historical conditions that help to build and consolidate a tax systems that is capable of regularly raising revenues from across the population through a broad tax like income tax.

From fiscal contract to a virtuous cycle

One key aspect of building this effective tax system, however, concerns the political conditions for raising revenues through taxes. Political systems that place stronger constraints on government leaders tend to collect higher tax revenues. This is because constraints on the leaders will diminish public concern that the government caters to elite interests. Institutionalized checks and balances reduce leaders’ discretion over public finance decisions and improve public accountability. This improves legitimacy and tends to make citizens and businesses more willing to pay tax.

For example, an effective parliament, that is independent from government, can keep checks on leaders by regularly overseeing and auditing the state’s budget, including taxation. These processes build “tax morale” and significantly increase revenues through tax. This is because citizens are more willing to pay taxes when they know that the state is more accountable to them. In other words, citizens enter a fiscal contract with the state. They are happier to exchange money through taxes for goods and services as they have more control over the state’s actions.

This creates a virtuous cycle. The quality of government improves because states that raise significant revenues from taxation may, in turn, face stronger public demands for accountability and representation. Recent research finds that tax revenues and constraints on leaders reinforce each other over time, bringing about a more sophisticated form of taxation levied from a broad tax base. Income taxation, in particular, can act as a powerful tool for redistributing wealth from the rich to the poor, and is a key feature of a modern fiscal state.

The challenges the world currently faces make a compelling case to build political support and commitment within countries to mobilize domestic revenues for development – that is, to increasingly finance development spending through taxes. This is not only a technocratic exercise. politics matters. While technical solutions, such as improved IT systems for tax collection and administration, are significant to achieving this end, understanding the politics behind fiscal contracts is of even greater importance.

Antonio Savoia is Reader in development economics at University of Manchester.

Kunal Sen is director of UNU-WIDER.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.

Watch Antonio Savoia explain on video why the ability to tax is important, and how it can be improved: