Taxing aid: the end of a paradox?

Abstract

Taxing aid was often discussed, but never implemented. This issue has now returned to the fore. First, many developing countries reform their tax system becoming more “reasonable” and eliminating one of the main justifications for aid-related tax exemptions. Second, the International Conference on Financing for Development held in Addis Ababa in August 2015 emphasised domestic revenue mobilisation as the main source of development finance. However, the broadening of tax base faces the proliferation of special tax arrangements, fuelled in part by the tax-exempt status of Official Development Assistance. Exemptions for project aid could represent as much as 3 per cent of Gross Domestic Product (GDP) in countries where tax revenues barely surpass 15 per cent of GDP. In addition to loss of tax revenue, tax exemptions for project aid have particularly damaging effects on the formalisation of the economies of recipient countries. Moreover, systematic exemption reduces the credibility of the policies of donor countries and the consistency of their aid policy. Last, the taxation of aid meets the commitment made by donors in the Paris Declaration on Aid Effectiveness (2005) to use recipient countries’ national Public Finance Management systems. This note reviews tax exemptions of foreign aid-funded projects: their consequences in terms of domestic revenue mobilisation in recipient countries, the induced inconsistency of foreign aid policy, their main historical justifications, and recent moves from some donor countries towards the taxation of their aid.