DP6007 | The Marginal Cost of Public Funds in Developing Countries: An Application to 38 African Countries

Publication Date

24/12/2006

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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 mode inspired by the ?1-2-3? model of Devarajan et al. (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 conventional 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. Moreover on average taxes on factors have high MCFs and taxes on imports and domestic goods have low MCFs. This suggests that welfare could be improved by increased reliance on VATs and reduced reliance on exports and factor taxes, and by reducing red tape barriers to business entry into the formal sector.