How governments behave affects the economy, especially how they raise revenue. The ability of government to forecast and juggle revenues from various sources is therefore a key to economic performance. Governments rely essentially on three types of revenue; taxes, aid and debt. Reform of taxes features prominently in adjustment programmes. Aid, and adjustment loans are often the same thing, while debt often helps to prompt the kind of macro-economic instability that raises the need for adjustment. If a shortfall in one source of revenue cannot be made up by drawing on another, expenditure will be directly affected and consequent strains on the budget can undermine economic reform programmes.

There is almost no existing literature on revenue instability. University of Nottingham researchers calculated and analysed three indices of revenue instability viz deviations around an observed trend (Index I), an average of year-on-year changes (Index II) and deviations around a forecast trend. (Index III). Index I is appropriate for evaluating the extent and causes of long-run instability. Index II represents short-run instability, while Index III measures unexpected instability, and is a key indicator of how governments react to revenue instability. The difference between III and I is a measure of instability that can be anticipated.

The resulting evidence points to a close link between revenue and expenditure instability over time, and suggests that governments have a very limited capacity to maintain expenditures when tax revenues fluctuate. It is clear that instability is considerable, and potentially of great economic importance - especially in the context of budget planning. The research in focus measures instability for tax, total revenue, expenditure, aid commitments and aid disbursements for a sample of countries in sub-Saharan Africa. The Nottingham study revealed signs that:

• expenditure instability is close to tax revenue instability
• tax revenue instability appears to affect expenditure
• aid instability is generally much higher than tax instability
• aid commitments are more unstable than aid disbursements
• trade tax dependence does not explain differences in revenue instability between developing countries, nor do differences in tax structure
• instability is greater in poorer, more open and inflation-prone economies with more variable output
• there is a strong correlation between expenditure and tax instability
• linkage between tax instability and aid instability is weak, implying that the determinants of both differ.

Tax instability is significant in SSA countries. Budget planning can, however, incorporate revenue trends so as to minimise unexpected instability. Other policy lessons arising from the study in hand were that:

• the linkage between tax and expenditure instability suggests that governments will have difficulty maintaining expenditures when taxes fluctuate
• where aid instability is greater than tax instability, recourse to aid to make up for tax revenue shortfalls would not be a reliable policy option
• there is no evidence that aid can be used with impunity to alleviate a tax shortfall.

Source(s):
1. Tax revenue instability with particular reference to sub-Saharan Africa, Journal of Development Studies, 31 (6): pp.883-902, Bleaney,M. et al (1995)
2. Aid and tax instability in SSA, CREDIT Research Paper #98 , Cnossen, T. & O. Morrissey (in preparation)
3. Consequences of tax revenue instability in sub-Saharan Africa, CREDIT Research Paper #95 Fielding, D. (1995)

Funded by: Department for International Development, UK (1994-95)

id21 Research Highlight: 1997-Dec-04

Further Information:
O. Morrissey
CREDIT and Department of Economics
University of Nottingham
NG7 2RD
UK

Tel: +44 (0) 115 951 5475
Fax: +44 (0) 115 951 4159
Contact the contributor: oliver.morrissey@nottingham.ac.uk

CREDIT and Department of Economics, University of Nottingham