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The Marginal Cost of Public Funds in Developing Countries: An Application to 38 African Countries

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The Marginal Cost of Public Funds in Developing Countries: An Application to 38 African Countries Michael Warlters1 and Emmanuelle Auriol2 3rd October 2007 Abstract: In this paper we propose estimates of the marginal cost of public funds (MCF) in 38 African countries. We develop a simple general equilibrium model inspired by the ’1-2-3’ model of Devarajan, Go, Lewis, Robinson, & Sinko (1994) that can handle taxes on the five major tax classes, takes account of the informal sector, and can be calibrated with little more than national accounts data. Sensitivity analysis suggests that our base case estimates are reasonably robust for purposes of tax reform. Contrary to con- ventional wisdom, differences in MCF are not strongly related to the wealth of the country. We hence show that a reasonable estimate of the average MCF in Africa is 1.17. On the other hand, there is a strong relationship between the size of the informal sector and the value of MCF. This suggests that welfare could be improved by reducing red tape barriers to business entry into the formal sector. JEL Classification Numbers: D43, H25, H26, H32, H60 1World Bank 2Toulouse School of Economics, corresponding author: [email protected] 1 1 Introduction Tax revenue as a proportion of GDP is typically 20% lower in African coun- tries than in rich OECD countries. Yet one of the salient features of African countries is an apparent under-provision of public goods in areas such as health, basic education or infrastructure. If there are unrealized benefits from public spending, why isn’t taxation increased to enable more public projects to be undertaken? There are various possible responses to this question, and the answer may be different in different countries. Some African govern- ments may not have the objective of maximizing social well-being, and so may under-provide public goods. Perhaps the assumption of high returns to public spending is false in practice, possibly because of inefficient or corrupt imple

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