Electronic copy available at: http://ssrn.com/abstract=1564442

Bangor Business School

Working Paper

BBSWP/10/006

DOES PAYING TAXES IMPROVE THE QUALITY OF

GOVERNANCE? CROSS-COUNTRY EVIDENCE

By

Y. Altunbas and John Thornton

Financial Studies Division

Bangor Business School

March 2010

Bangor Business School

Hen Goleg

College Road

Bangor

Gwynedd LL57 2DG

United Kingdom

Tel: +44 (0) 1248 382277

E-mail: business@bangor.ac.uk

Electronic copy available at: http://ssrn.com/abstract=1564442

2

Does paying taxes improve the quality of governance?

Cross-country evidence

Abstract

A growing economics literature argues that taxation can strengthen the quality

of governance and public sector institutions by making governments more

responsive and accountable to their citizens, building capacity, and improving

public policy. In this paper, we provide empirical support for this view. Using

data on a cross-section of developed and developing countries, we find that

taxation improves the quality of governance and that those taxes that are borne

most directly by citizens are the most important in improving governance. Our

results are robust to different estimation methodologies, to variations in the

country sample, and to controlling for the influence of variables that have been

identified as affecting the quality of governance. The results suggest that

policies aimed at mobilizing tax revenues may be justified based on the greater

accountability of government that may result.

JEL classification: C31, H11, H20, O11,

Keywords: Cross-section, taxation, governance, development, state capacity

3

Does paying taxes improve the quality of governance?

Cross-country evidence

1. Introduction

There is now a substantial economics literature that argues that taxation can

strengthen the quality of governance and public sector institutions by making

governments more responsive and accountable to their citizens, by building

capacity, and by improving public policy. However, empirical evidence to this

effect—supportive or otherwise—is scant. In this paper, we add to this scarce

literature by testing for direct evidence of a relationship between tax revenue

and changes in indicators of the quality of governance in a cross-section of

developed and developing economies. We find that higher tax revenues (in

relation to GDP) are consistently associated with improvements in the quality of

governance. This result is robust to different estimation methodologies, to

variations in the country sample, and to controlling for the influence of

variables that other studies have identified as affecting the quality of

governance. Our results support the notion that policies aimed at mobilizing tax

revenues may be justified based on the greater accountability of government

that may result.

The paper is organized as follows. Section 2 summarizes arguments in the

literature on how taxation can improve the quality of governance. Sections 3

and 4 describe the data and our methodology, respectively. Our empirical

results are presented in section 5, and a final section concludes.

4

2. How taxation can improve governance

Traditionally, high taxation has been associated with interventionist

governments and as a likely indicator of poor governance (Smith 1976, North

1981, Knack and Keefer 1995). However, there is a growing literature that

argues that high taxation can support better governance by binding together

governments and citizens (e.g., Bräutigam, 2002, 2008; Fjeldstad, and Moore,

2008; Collier 2007; Moore, 1998, 2007). In this view, tax decisions are the

outcome of a bargain between governments and citizens. Citizens respond to

tax demands by organizing to negotiate tax levels, monitor how taxes are

collected and used, and to influence public policy. The bargaining process is

viewed as improving governance in several ways. First, it makes governments

more responsive and accountable to their citizens. Second, as tax compliance

increases, state capacity improves and the taxation process becomes more

efficient and predictable. Third, better public policy results from debate and

negotiation with citizens. This view also stresses that the composition of

government revenues is likely to affect the quality of governance. In particular,

the quality of governance is likely to be poor where governments receive

substantial non-tax revenues—for example, from foreign aid inflows or natural

resource rents—because they have less need to negotiate tax demands and to

make concessions to citizens. In turn, citizens are less motivated to scrutinize

how government revenues are collected and spent and have less leverage over

public policy. The quality of governance might even be undermined if

governments respond to new non-tax revenues reducing domestic taxation. Not

surprisingly, aherents to the view that taxation promotes good governance have

tried to taxation at the core of countries‖ development efforts.

5

The direct empirical evidence on the relationship between taxation and

governance is both sparse and mixed. For example, La Porta et al. (1999) report

that richer countries impose higher taxes, have better tax compliance, and

larger governments in their cross-section study of the determinants of the

quality of government; and Hoffman and Gibson (2005) find that local

governments in Tanzania and Zambia produce more public services as the share

of local taxes in their budgets increases, whereas revenue in the form of

transfers from the central government and foreign assistance increases the

share of local budgets consumed by employee benefits and administrative costs.

However, Ross (2004) finds no association between taxation and democracy

(which he employs as an indicator of good governance) in a pooled time-series

study of 113 countries; and Juul (2006) finds no relationship between the

decentralization of tax revenue and the strengthening of local democratic

structures in Senegal.

There is some empirical evidence that the composition of government revenues

can affect the quality of governance. For example, in cross section studies of the

impact of foreign aid inflows, Busse and Gröning (2009) and Bräutigam and

Knack (2004) find them to be associated with a deterioration in governance, and

Knack (2001) finds that aid given through technical assistance erodes

bureaucratic quality and the rule of law, but that aid levels are not significantly

related to corruption. In contrast, Tavares (2003) reports that foreign aid

inflows decrease corruption in recipient countries. In studies of the impact of

natural resource rents, Isham et al. (2005) and Sala-i-Martin and Subramanian

(2003) find that governments use them to mollify dissent, avoid accountability,

and ease pressures for institutional reform; Leite and Weidmann (2002) find

that they increase corruption, and Collier and Hoeffler (2005) find that

6

competition for rents stunts institutional development and increases the

probability of civil conflict.

Finally, there is some evidence that governments mobilize less revenue from

domestic taxation when they receive large inflows of foreign aid and significant

natural resource rents. For example, Brautigam and Knack (2004), Gupta et al.,

(2004), and Swaroop et al., (1999) report substantial offsets between foreign aid

inflows and domestic tax revenues, and Bornhorst et al., (2009) report a

substantial offset between natural resource rents and revenue from domestic

taxes.

In contrast, many empirical studies provide direct evidence that poor

governance adversely affects economic performance, including by reducing

investment and GDP growth (Braun and Di Tella, 2000; Mauro, 1995; Keefer

and Knack, 1995), increasing inflation (Al-Marhubi, 2000; Blackburn et al.,

2008), widening income inequality and poverty (Gupta et al., 2002), reducing

foreign direct investment (Wei, 2000; Lskavyan and Spatareanu, 2008), favoring

military over other public spending (Gupta et al., 2001), and biasing the

provision of public goods away from education (Mauro, 1998). For any of these

reasons, countries with poor governance may become poor performers.

3. Data description

Our indicator of governance is the quality of governance index produced by the

International Country Risk Guide (ICRG). This is a composite of three indices,

namely an index of bureaucratic quality, an index of corruption in government,

and an index of the rule of law. All three indices are clearly linked to

7

governance, with the latter index aimed at reflecting the government‖s

administrative capacity in enforcing the law, and the potential for rent-seeking

associated with weak legal systems and insecure property rights. Each index is

subjective and is scaled from 0 to 6, with higher values indicating, respectively,

a higher quality of bureacracy, less corruption, and better law and order

enforcement. The composite quality of governance index, therefore, is an 18-

point scale where the data are annual averages of monthly observations. The

underlying data on tax revenue are drawn from the International Monetary

Fund‖s (IMF) Government Finance Statistics and World Economic Outlook

databases. Tax revenue is expressed in relation to GDP. The data are annual

averages and include total tax revenue and revenue from the personal income

tax, the corporate income tax, social security taxes, the sales tax, and taxes on

international trade. The dataset comprises annual observations for 117

developed and developing economies for the period 1984-2006, though

observations are not available for all countries for all years. The sample period

for each country in the dataset is given in the Appendix Table 1.

Many variables have been found to affect the quality of governance (e.g., La

Porta et al., 1999; Swamy et al., 2001; Treisman, 2000), and we control for

several of them in our estimates. Our baseline control variables are a country‖s

population and GDP per capita, which are drawn from Heston et al. (2009).

Population is included to capture economies of scale in establishing effective

institutions (Srinivasan, 1986; Knack, 2001); and per capita GDP is included to

capture increases in the volume and size of transactions, which would increase

the benefits of developing institutions such as commercial codes and their

associated adjudication and enforcement mechanisms (Knack, 2001; Rosenberg

and Birdzell, 1986).

8

We also report results from estimates that include three additional controls

because their influence on governance has been found to be robust in a range of

empirical studies (Serra, 2006). These are: a dummy variable equal to 1 if a

country achieved colonial independence after 1945, the data for which is derived

from The CIA World Factbook 2010;1 a country‖s degree of ethnic

fractionalization, the data for which is taken from Alesina et al., (2003); and a

dummy variable equal to 1 if a country has maintained democratic institutions

for a continuous period since 1950, which is taken from Serra (2006). Colonial

independence after 1945 is included because public institutions take time to

create and adapt to local circumstances, so that younger countries may be more

prone to poor governance; in addition, institutions inherited from a former

colonial power may be ill suited to local needs making them vulnerable to

irregular practices. Ethnic fractionalization is included because political

theories predict that, as ethnic heterogeneity increases, governments become

more interventionist and less efficient, the quality of public goods falls and

political freedoms are restricted (La Porta et al. 1999). Tanzi (1995) suggests

that in developing countries noneconomic ties are strong and government

officials tend to benefit their next of kin and ethnic group. Continuous

democracy is included to because governance has been found to be better in

democratic countries and in those with a freer press and more vigorous civic

associations (Treisman, 2000). Table 1 reports basic statistics for the key

variables.

1 The CIA data can be downloaded at: https://www.cia.gov/library/publications/the-world-factbook/.

9

4. Methodology

If taxation improves the quality of governance, then countries with higher tax

revenues should record better scores on the quality of governance index over

time. Accordingly, our dependent variable is the change in the quality of

governance index, ∆QGOV, which we measure as the end-of-period value of the

index minus the initial value of the index. In our baseline estimates we include

as independent variables: the average ratio of tax revenue to GDP, TREV, to

capture the impact of taxation on governance; the initial value of the quality of

governance index, IQGOV, to capture regression-to-the-mean effects and to

control for the limited opportunity of low- and high-rated countries,

respectively, to decrease and increase their scores; the change in population

over the sample period expressed as a fraction of its initial value, POP, and

the change in per capita GDP over the sample period expressed as a fraction of

its initial value, GDP. Therefore, our baseline specification is:

∆QGOVi = + 1TREVi + 2i IQGOV+ 3 POPi + 4 GDPi + i (1)

The OLS estimates of equation (1) could suffer from endogeneity bias in the

sense that tax revenues may also be influenced by the quality of governance.

For example, Flatters and Macleod (1995) and Toye and Moore (1998) discuss

collusion between tax officials and taxpayers to understate tax liabilities, and

Tanzi and Davoodi (1997) and Friedman et al., (2000) have provided evidence

that countries with more corruption tend to collect fewer tax revenues in

relation to GDP, all else being equal. The presence of endogeneity has generally

been dealt with in cross-sectional analyses through the use of instrumental

variables (IV). We try to deal with the possible endogeneity of tax revenues by

10

adapting a methodology used by Lee and Gordon (2005) in their study of

taxation and economic growth, in which they instrument corporate and personal

tax rates by the average of these tax rates in neighboring countries. Thus, our

instrument for the tax revenue ratio is the average tax revenue ratio in

neighboring countries, where neighboring countries tax ratios are weighted by

the inverse of the distance between the two countries.2 The correlation between

the actual tax ratio and the tax ratio in neighboring countries (the ―instrument‖)

is high (0.87) but the level of governance in a country that is small relative to

the regional and world economy should have virtually no effect on the tax ratio

in these other countries. There seems to be little reason to expect tax revenue

ratios in neighboring countries to impact on a county‖s governance other than

though its influence on that country‖s tax revenue ratio. As additional

instruments, we use dummies identifying countries‖ legal origins (British,

French, Socialist, Germanic, or Scandinavian) because of their success in

studies relating public sector activities to governance (e.g., Fisman and Gati,

2002; de Mello and Barenstein, 2001; Mauro, 1998). The instruments predict

the actual tax ratio quite well, with the R2 for the first-stage being 0.76.

5. Empirical Results

Results using OLS are presented in columns 1 and 2 of Table 2. The coefficients

on the tax revenue ratio are positive and statistically significant at the 95

percent level. However, the impact of taxation on the quality of governance

2 Distance measures between two countries come from CEPII, Centre D‖Etudes Prospectives et

D‖Informations Internationales, (http://www.cepii.fr/). Geodesic distances are calculated following

the great circle formula, which uses latitudes and longitudes of the most important

cities/agglomerations in terms of population.

11

index appears to be relatively small with the coefficients on the tax ratios

indicating that an increase in the tax revenue share of GDP by 17-21 percentage

points is needed to increase the quality of governance index by 1 point. Only

three countries in the sample managed an increase in their tax ratios by

amounts approaching these magnitudes (Bolivia 16.9 percentage points;

Dominican Republic 16.3 percentage points, and Ghana, 15.8 percentage

points), and the increase in these tax revenue ratios mainly reflected recoveries

from economic crisis that returned tax ratios close to pre-crisis levels. The

average increase in the tax ratio for all countries in the sample was just 1

percentage point.3 The impact of increases in the tax revenue ratio on the

quality of governance is somewhat greater in the IV results, which are reported

in columns 3 and 4 of Table 2. These results indicate that an increase in the tax

revenue share of GDP by 11-14 percentage points is needed to raise the quality

of governance index by 1 point. A further six countries in the sample (Brazil, El

Salvador, Jordan, Kazakhstan, Turkey, and the US) experienced increases in

their tax ratios by orders of magnitude approaching these amounts. The

instrument appears to be valid. For example, the p-values for the Durban-Wu-

Hausman endogeneity test in column 4 of Table 2 is 0.049.

In both the OLS and IV estimates, there is a quite strong regression-to-the-

mean effect. Other things being equal, a country with an initial quality of

governance index 1 unit greater than another country will experience a decline

of 0.38 to 0.41 of a point. In addition, changes in population and in per capita

GDP both have statistically significant and positive effects. Each 10 percent

increase in population and in GDP per capita is associated with an increase in

3 Increases in the tax ratio ranged from -14 percentage points (Israel) to +16.9 percentage points

(Bolivia).

12

the quality of governance index of 0.21-0.24.

Table 3 replicates the IV regressions from Table 2, substituting as the

dependent variable changes in each of the three components of the quality of

governance index. The bottom row of the table reports the OLS coefficients and

standard errors for tax revenue. Correlations among the three separate

components of the quality of governance index range from 0.27 to 0.32,

indicating that the strength of the tax-governance relation could vary

substantially across the three governance indicators. There are a few notable

differences when the results are compared to those reported in Table 2. In both

the IV and the OLS results, tax revenue is positively and significantly related to

improvements in bureaucratic quality and the rule of law, but not related

significantly to corruption. Changes in GDP per capita and in population also

are positive and significantly related to improvements in bureaucratic quality

and the rule of law, but not to corruption.

Table 4 sheds some light on the role of different taxes in improving the quality

of governance. If taxation promotes better governance by encouraging citizens

to organize to negotiate tax levels, monitor tax collection and usage, and to

influence public policy, it seems reasonable to expect that those taxes that fall

directly on citizens—such as personal income and social security taxes—would

be the most effective in improving governance. This is precisely what seems to

be the case. The IV results reported in Table 4 (and the OLS coefficients and

standard errors for tax revenue reported in the final row of the table) indicate

that the revenue ratios from personal income taxes, social security taxes, and

the sales tax have a positive and statistically significant effect on the quality of

13

governance index.4 In practice, these are also the taxes that contribute the most

to government revenues. For example, the average contribution of the sales tax

to total tax revenue in our sample was 30.2 percent, and for social security

taxes and the personal income tax it was 21.5 percent and 15.7 percent of total

tax revenue, respectively. In contrast, the influence on the quality of

governance of the corporate income tax ratio (averaging 12.4 percent of total

tax revenue) and the international trade tax ratio (11.8 percent of total tax

revenue) is not statistically significant. Moreover, as revenues from personal

income, social security, and sales taxes tend to increase as a proportion of total

tax revenue as a country‖s level of development progresses (Goode, 1984;

Farhadian-Lorie and Katz, 1989), the change in the composition of tax revenues

as well as the level of taxation would appear to be important in explaining the

association between relatively high total tax revenues ratios and better

governance over time.

In Table 5, we report results from IV estimates (with OLS results for the tax

revenue and interaction variables reported in the final rows of the table) that

include the three additional control variables found by Serra (2006) to be robust

in their relation to governance indicators (mainly corruption) across a range of

empirical studies. Specifically, the results show how colonial independence,

ethnic fractionalization, and continuous democracy interact with taxation to

affect the quality of governance. The results indicate marked differences in

their impact. The overall impact of taxation on governance remains statistically

significant and positive but is reduced markedly when the coefficient on the

interaction variable for colonial independence after 1945 is included as an

4 The correlation between the different tax revenue ratios and their respective instruments is 0.76

for the personal income tax, 0.67 for the corporate income tax, 0.78 for the sales tax, 0.83 for

international trade taxes, and 0.69 for social security taxes.

14

independent variable (column 1). For example, the size of the tax revenue

coefficient falls from 0.0676 (column 4 of Table 2) to 0.0371 (column 1 of Table

5). The overall impact of taxation on governance becomes negative when the

interaction variable for ethnic fractionalization is included, with the (combined)

coefficient falling to -0.076 (column 2 of Table 5); and inclusion of the

interaction variable for continuous democracy reduces the overall impact of the

tax ratio by about half (column 3 of Table 5).

Other robustness tests

The positive association between tax revenue and the quality of governance

appears robust to alternative estimation methodologies and to reasonable

changes in the cross-country sample. As an alternative methodology (to OLS

and IV), we organized countries into quartiles according to the progress made in

improving the quality of governance over the sample period and employed probit

estimation. In this case, the dependent variable was equal to 1 if a country was

located in the highest quartile and zero otherwise. The results turn out to be

similar to the OLS and IV results reported in Table 2. For example, the

coefficient (and standard error) on the tax revenue ratio in an equation that

includes the change in population and the change in GDP per capita as control

variables is 0.0721 (0.0199), which is significant at the 99 percent level of

confidence. The full probit regression results are reported in Appendix Table 2.

The results from estimates of equation (1) over different country sub-samples

are reported in Table 6. The table reproduces the tax revenue coefficients from

columns 1 and 2 of Table 2 for comparison purposes and the following rows

show the corresponding results (OLS and IV) for total tax revenue for various

15

alternative sub-samples. Many transition economies have experienced

substantial volatility in their tax revenue ratios reflecting a combination of tax

reform and output volatility in the transition process. Row 2 deletes these

countries from the sample. The tax revenue coefficient remains positive and

statistically significant. Row 3 deletes from the sample the high-income OECD

economies. These economies typically have high tax ratios relative to other

countries and high scores on the quality of governance index that changed very

little over the sample period. The tax revenue coefficient rises slightly relative

to the base case and remains positive and significant.

The composition of government revenues may affect governance adversely if a

large share of revenue is form non-tax sources, such as foreign aid inflows and

natural resource rents. In this regard, Bräutigam and Knack (2004) and Gupta

et al., (2004) show that economies receiving substantial foreign aid—mainly

African economies—exhibit a reduced tax revenue mobilization effort. Row 4

deletes from the sample the African economies, which tend to have among the

lowest tax revenue ratios and the lowest scores on the quality of governance

index. The tax revenue coefficients remain positive and statistically significant,

though the coefficients are somewhat larger than in the base case. Similarly,

Bornhorst et al., (2009) have shown that economies receiving substantial

revenues from hydrocarbons exports exhibit a reduced domestic revenue effort.

Row 5 of the table deletes these countries from the sample. The tax revenue

coefficients remain positive and significant and are broadly unchanged from the

base case.

6. Conclusion

16

A growing literature argues that taxation can strengthen the quality of

governance and public sector institutions by making governments more

responsive and accountable to their citizens, by building capacity, and by

improving public policy. In this paper, we have provided empirical support for

this view. Using data on a cross-section of developed and developing countries,

we find that taxation improves the quality of governance and that revenue from

those taxes that are borne most directly by citizens are the most important in

improving governance. The main exception to this general result is the case of

countries where there is a high degree of ethnic fractionalization, which

appears to interact with tax revenue ratios in a way that more than offsets any

beneficial effect of taxation on the quality of governance. Our results are

statistically significant and are robust to different estimation methodologies, to

variations in the country sample, and to controlling for the influence of other

variables that are generally robust in their effects on the quality of governance.

We believe that our results support the notion that policies aimed at mobilizing

tax revenues may be justified based on the greater accountability of

government that may result.

17

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Appendix Table 1. Countries and sample periods

Country Period Country Period Country Period

Albania 1995-1998 Gambia, The 1985-2001 Nigeria 1984-1987

Algeria 1996-2006 Germany 1984-2006 Norway 1984-2006

Argentina 1986-2003 Ghana 1984-2004 Oman 1984-2001

Armenia 2003-2006 Greece 1984-2006 Pakistan 1994-2004

Australia 1984-2006 Guatemala 1984-2006 Panama 1984-2000

Austria 1984-2006 Guinea 1989-1999 Papua New Guinea 1984-2002

Azerbaijan 1998-1999 Honduras 2003-2006 Paraguay 1984-2006

Bahamas, The 1984-2005 Hong Kong, China 2002-2006 Peru 1990-2005

Bahrain 1984-2001 Hungary 1984-2006 Philippines 1984-2004

Bangladesh 2001-2004 Iceland 1984-2006 Poland 1994-2006

Belarus 1998-2001 India 1984-2006 Portugal 1984-2006

Belgium 1984-2005 Indonesia 1984-2004 Romania 1991-2004

Bolivia 1985-2006 Iran, Islamic Rep. 1984-2006 Russian Federation 1994-2006

Botswana 1984-1996 Ireland 1984-2005 Senegal 1992-2001

Brazil 1991-1998 Israel 1984-2006 Sierra Leone 1985-1999

Bulgaria 1998-2006 Italy 1984-2006 Singapore 1984-2005

Burkina Faso 1985-2000 Jamaica 1993-2006 Slovak Republic 1996-2001

Cameroon 1984-2006 Japan 1984-2005 Slovenia 1998-2006

Canada 1984-2006 Jordan 1984-2006 South Africa 1984-2001

Chile 1984-2006 Kazakhstan 1998-2006 Spain 1984-2004

China 1990-2005 Kenya 1984-2006 Sri Lanka 1984-2005

Colombia 1984-1999 Korea, Rep. 1984-1997 Sweden 1984-2006

Congo, Dem. Rep. 1988-2002 Latvia 1998-2006 Switzerland 1984-2005

Congo, Rep. 1995-2003 Lebanon 1993-1999 Syrian Arab Republic 1986-1999

Costa Rica 1984-2001 Lithuania 1998-2006 Tanzania 1992-2001

Cote d'Ivoire 1985-2006 Luxembourg 1984-2006 Thailand 1984-2006

Croatia 1998-2006 Madagascar 1988-2001 Togo 1984-2006

Cyprus 1984-2006 Malawi 1984-2001 Trinidad and Tobago 1993-2005

Czech Republic 1993-2006 Malaysia 1984-2003 Tunisia 1984-2006

Denmark 1984-2006 Mali 1984-2006 Turkey 1984-2001

Dominican Republic 1984-2004 Malta 1986-2004 Uganda 1991-2003

Ecuador 1984-1994 Mexico 1984-2000 Ukraine 1999-2006

Egypt, Arab Rep. 1984-1997 Moldova 1998-2006 United Kingdom 1984-2005

El Salvador 1984-2006 Mongolia 1992-2001 United States 1984-2006

Estonia 1998-2006 Morocco 1984-2003 Uruguay 1984-2006

Ethiopia 1984-2002 Namibia 1990-2002 Venezuela, RB 1985-2005

Finland 1984-2006 Netherlands 1984-2006 Vietnam 1994-2004

France 1984-2006 New Zealand 1986-2001 Zambia 1984-2005

Gabon 1984-2001 Nicaragua 1990-2000 Zimbabwe 1985-2001

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Appendix Table 2.

Tax revenue and the quality of governance: probit regression results

Constant -2.4332*** -2.7026***

(0.4064) (0.7113)

Change in quality of governance index 0.0913 0.0839

(0.0574) (0.0652)

Tax revenue/GDP 0.0804*** 0.0721***

(0.0166) (0.0199)

Population change/initial population -0.1716

(0.8973)

GDP per capita change/intial GDP per capita 1.2851**

(0.5247)

Pseudo R2

0.198 0.244

Wald chi2(2) 23.36 32.85

Prob > chi2 0.000 0.000

N 117 117

The dependent variable takes the value of 1 if the country is in the top quartile

of good governance.

*, ** and *** indicate statistical significance at the 10, 5 and 1 percent, respectively.