Raising fiscal revenue in times of crisis

The multiple crises that developing countries are facing today constitute a major setback for development.  The war in Ukraine and COVID-19 aftershocks have resulted in a steep rise in prices of food, fertilizers, and energy. This in turn has contributed to high levels of inflation and rising interest rates, as well as to the risk of stagflation.

Globally, food and energy prices have increased the risks of food insecurity, malnutrition, and hunger, hitting the world’s poorest the hardest. Poor families had already borne the greatest burden of the COVID-19 crisis. In 2020 alone, the number of people living below the extreme poverty line, on less than $2.15 per day, rose by over 70 million—the largest increase at least since 1990. And many people who were already in extreme poverty became even poorer. Vulnerable families also faced the largest setbacks in health and education. About 70% of children in low- and middle-income countries are in learning poverty—meaning that at the age of 10, they are unable to read or understand a basic text.

In addition, long-term challenges, especially due to climate and demographic changes, are becoming more urgent, and their economic and fiscal impacts more prominent. The recent floods in Pakistan have left over 1,500 people dead, while droughts are taking a toll in the Horn of Africa and in South America, affecting food production and hydropower generation and throwing millions of people into severe food insecurity.

The multiple crises have resulted in significant revenue losses in many developing countries. At the same time, they create additional financing needs to mitigate adverse impacts on vulnerable families and businesses. As a result, the fiscal position of most developing countries has deteriorated further. More than half of the low and lower-middle income countries that are eligible for IDA financing, the World Bank’s fund for the poorest, are now at high risk of debt distress or already in debt distress. 

This exacerbates the massive and growing financing gaps in developing countries’ pursuit of Green, Resilient, and Inclusive Development (GRID).

So how can countries reduce these large financing gaps and create much-needed fiscal space—especially as rising interest rates increase the cost of debt financing?

First, improving countries’ capacity to mobilize resources efficiently will be critical to restore their fiscal and debt sustainability.

Induced by the COVID-19 pandemic, tax revenues in 2020 declined by 12% in real terms globally, and by 15% in low- and lower-middle-income countries. Governments need to find the most productive ways to accelerate revenue recovery while protecting the poor and vulnerable , reducing the burden on investment and competitiveness and promoting GRID. 

The current high-inflation environment presents an opportunity for countries to review and make their tax systems more neutral to inflation. By indexing different components of direct and indirect taxes, governments would help mitigate the impact of inflation on lower-income groups while ensuring that real tax revenues keep up. This could be done to specific excise taxes, personal income tax exemption thresholds, and deduction and credit amounts.

Aiming not only for higher but, importantly, more equitable revenue collection is a central component of the World Bank’s domestic resource mobilization approach. We cannot emphasize enough the importance of reforms that broaden the tax base and enhance fairness and equity. This includes enhancing the taxation of often undertaxed sources, such as digital transactions, property, and wealth. Rationalizing tax expenditures and making taxes more progressive by shifting from indirect to direct taxes are also positive measures. Environmental and health-related taxes should be considered—they can provide incentives for the much-needed transition toward renewable energy and a healthier lifestyle. Weaknesses in the international corporate tax system should also be addressed to reduce harmful tax competition, tackle tax avoidance, and enhance the fight against tax evasion.

Second, reforms to tax incentives and subsidies would be critical.

To mitigate the impact of high energy and food prices, many countries around the world have introduced or increased subsidies. Yet subsidies are often poorly targeted.  For example, half of all spending on energy subsidies in low- and middle-income countries benefit the richest 20 percent of the population, who consume more energy.

Meanwhile, cash-transfer programs tend to be more effective in reaching the most vulnerable groups, with 60 percent of spending on these transfers going to the bottom 40 percent of the population.

Fossil fuel and agricultural subsidies alone could free up to $1.2 trillion in funds. Reorienting such resources to protecting the most vulnerable would be more effective—along with supporting structural reforms that enhance food security and the transition to more sustainable energy sources.

Our vision at the World Bank is that better and more equitable revenue mobilization is crucial to achieve a more inclusive, resilient, and sustainable growth.  We are strongly committed to supporting countries in pursuing these objectives.