Aid can either reinforce or undermine tax systems and tax culture, depending on how it is channelled. International guidance suggests that donors should combine different aid modalities, adjusting them to local conditions (OECD, 2013). These should be coherent and coordinated, and ensure ownership and alignment with partner country government preferences. Guidance also suggests that donors ensure transparency within the recipient country regardless of the aid modality employed, and make more use of graduated funding mechanisms with revenue-related triggers (variable tranches, cash-on-delivery) (OECD, 2013). Donors should be prepared to disengage when aid for tax support does not achieve results, but there should be realistic expectations to avoid suddenly cutting off support. No single aid modality is always most effective in shifting elite incentives in relation to taxation. There are concerns that general budget support may weaken incentives for revenue mobilisation, although empirical evidence on this is inconclusive.
Tax exemptions on aid-funded goods and services have long been discussed in the international community (UN, 2005; ITD, 2006) and there is a strong consensus that they are undesirable (Diallo, 2013; Prichard et al., 2012; Fjeldstad, 2009; MFA, 2013). While there is evidence on the impact of tax exemptions in general (see Economic growth) there is limited evidence specifically on tax exemptions of aid-funded goods and services. Prichard et al. (2012) argue that by paying tax on aid-funded goods and services, donors can reinforce the norm of tax compliance, reinforce the quality of tax systems and reduce administration costs in developing countries. Diallo (2013) notes that removing tax exemptions could help to make tax systems simpler, reduce management costs, minimise the risk of tax fraud and strengthen the neutrality of sales taxes, such as VAT. On the other hand, tax exemptions for aid funds can help ensure that the funds achieve their intended purpose, and removing them would require coordinated action by all donors to avoid price, cost and access disadvantages which would impact on development outcomes (O’Brien, in International Development Committee, 2012). At present some bilateral (Denmark, Norway) and multilateral (World Bank) donors no longer require tax exemptions (MFA, 2013).
Key reading
OECD. (2013). Tax and Development: Aid Modalities for Strengthening Tax Systems. Paris: OECD.
This OECD publication provides practical guidance for policy makers and practitioners based on the results of a literature review, a survey of aid agency officials and six country case studies (Ghana, Guatemala, Liberia, Mali, Mozambique, and Tanzania). The study examined seven aid modalities for supporting tax programmes and highlights the following strengths and weaknesses: (1) General budget support is useful in conditions of good public financial management capacity, it aligns support with national priorities, but may weaken incentives for domestic revenue mobilisation. (2) Sector budget support has similar strengths and weaknesses to general budget support, it creates direct links between funding and PFM performance, and is highly effective for coordinating donor work on revenue issues. (3) Basket financing is well suited to coordinating multi-donor funding for tax programmes, but is less closely aligned with country systems than budget support. (4) Other multi-donor instruments such as multi-donor trust funds can be used for coordination though basket funding is preferable where there is adequate local management capacity. (5) Bilateral projects or programmes carry risks of lack of coordination among donors, and of being donor- rather than country-led, but can be effective if the recipient country exercises strong ownership and leadership. (6) Triangular cooperation can be comparatively lower in costs than other forms of technical assistance, although there are limits to countries’ absorptive capacity. (7) In-kind support can be more responsive to recipient country needs than donor-led interventions.
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Diallo, I. (2013, March 14). Tax exemptions for aid-funded projects: reasons for change [Blog post]. Brighton: International Centre for Taxation and Development.
This opinion piece by a Senegalese tax official outlines the use of, and problems with, tax exemptions of aid-funded goods. Tax exemptions for aid-funded projects are mainly VAT, customs duties, excise duties, and registration fees. For recipient countries, granting tax exemptions are effectively a conditionality tied to aid rather than a political choice. While the aid helps provide public goods with economic and social benefits, there is still a forgoing of significant tax revenue. Tax exemptions, including those for aid-funded projects, result in more complex tax systems, additional management costs both for tax payers and tax administrations, risks of tax fraud, and restrictions on the right to refunds affecting the neutrality of VAT. Paying taxes on aid-funded goods and services essentially acts as budget support, which is widely agreed by donors to be the preferable modality as it allows funds to be used to finance national priorities and reinforces public financial management systems. The official concludes that reviewing tax exemptions for aid-financed projects should be a priority.
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- Prichard, W., Brun, J., & Morrissey, O. (2012). Donors, aid and taxation in developing countries: An overview (ICTD Working Paper 6). Brighton: Institute of Development Studies. See document online
- Fjeldstad, O.-H. (2009). Donors: Preaching tax morale but practicing tax avoidance. In Chr. Michelsen Institute (Ed.), CMI Annual Report 2008. Bergen: Chr. Michelsen Institute. See document online
- International Development Committee. (2012). Tax in developing countries: Increasing resources for development (Fourth Report of Session 2012–13 (1), ev50). London: The Stationary Office. See document online
- ITD. (2006). Tax treatment of donor-financed projects (Discussion paper). International Tax Dialogue (ITD). See document online
- MFA. (2013). Sharing for prosperity: Promoting democracy, fair distribution and growth in development policy (Meld. St. 25 (2012–2013) Report to the Storting). Oslo: Norwegian Ministry of Foreign Affairs (MFA). See document online
- UN. (2005). Tax aspects of donor-financed projects (Background note E/C.18/2005/9). New York: United Nations. See document online
