National Debt Forgiveness Reduces Tax Efforts, Perpetuates Aid Dependence, New Research Finds

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While Greece’s call for debt relief grabs headlines, new research at Georgia State University shows the international financial community may be doing serious harm when it relieves developing countries of their loan repayment obligations.

“Debt forgiveness acts as a convenient substitute for otherwise politically costly efforts to increase tax revenues,” Martinez-Vazquez said.

While Greece’s call for debt relief grabs headlines, new research at Georgia State University shows the international financial community may be doing serious harm when it relieves developing countries of their loan repayment obligations.

“Debt forgiveness has the potential to lower financial discipline among governments who receive this form of relief,” said public finance economist and study co-author Jorge Martinez-Vazquez, a Regents Professor in the Andrew Young School of Policy Studies and director of the school’s International Center for Public Policy, and Leanora Brown, an economist at the University of Tennessee Chattanooga. “Our research shows that a bailout creates expectations about receiving debt forgiveness time and time again, lowering tax efforts and thus perpetuating a cycle of aid dependence.”

Their working paper, which examines data for 66 countries from the years 1998-2008, is the first to investigate the impact of debt forgiveness on a country’s tax efforts.

“Our purpose was to show whether the otherwise well-intentioned actions of the international financial community regarding debt forgiveness has helped cause the low-tax effort observed among many developing countries,” said Martinez-Vazquez.

They found that debt forgiveness seems to trigger a significant decline in a country’s actual tax-to-Gross Domestic Product ratios.

“Debt forgiveness acts as a convenient substitute for otherwise politically costly efforts to increase tax revenues,” Martinez-Vazquez said.

The international finance community, which includes The World Bank and the International Monetary Fund, has earmarked as much as $400 billion for debt write-offs in more than 50 developing countries since 1996.

Although a debt write-off may be considered necessary to improve a country’s resources and enhance investments, economic growth and development, it can also compromise the sustainability of a country’s fundamental development goals, Martinez-Vazquez said.

“Overall,” he said, “it discourages developing countries from improving their tax effort and gaining sustainable fiscal independence.”

The study offers strong policy implications for both developed and developing countries:

•Developed donor countries could include restrictive covenants in debt forgiveness contracts that compel developing countries to sustain or increase their current tax collection efforts.
•The international financial community could tie access to debt forgiveness monies to the creditworthiness of developing countries, inducing them to raise their tax efforts. Failure on their part to increase their tax efforts could result in losing access to future loans.

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Leah Seupersad
Georgia State University
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