Chapter 7. What sources of internal resources are available to fragile contexts?

Sara Batmanglich

Cora Berner

Development Co-operation Directorate, OECD

This chapter considers internal financial resources available to the 58 contexts considered fragile in the 2018 fragility framework, in recognition that the Addis Ababa Action Agenda identifies domestic resources as a critical source of financing for development. It discusses the particular challenges facing fragile contexts in mobilising domestic revenues, particularly tax revenues, and in budgeting for addressing fragility across sectors. This chapter reviews opportunities and challenges presented by natural resource wealth, and the informal economy in fragile contexts, including the latter’s implications for strengthening small and medium-sized enterprises. It concludes by emphasising ways in which the donor community can better support mobilisation of domestic revenue in fragile economies.

While data on domestic resources are improving, significant gaps remain in the information available, especially for fragile contexts. This makes it difficult to build a complete picture of the financing landscape in most fragile contexts. It also makes it hard to evaluate how the collective impact of all flows could be harnessed to address fragility and build resilience. Nevertheless, domestic resources are recognised as one of the largest and most significant types of financing. The Addis Ababa Action Agenda (UN, 2015, p. 11[1]) underscored the critical role these resources must play in financing sustainable development. The Addis Tax Initiative (ATI) was established in recognition of the need to strengthen one key aspect of this role (International Tax Compact, 2017[2]).

7.1. Domestic resource mobilisation

In addition to contributing to the achievement of the Sustainable Development Goals (SDGs), mobilising domestic revenues in fragile contexts plays a crucial role in building a robust social contract between the state and its citizenry, demonstrating the commitment and accountability of the state to public goods and reducing dependency on external assistance. The impact of tax systems on societies extends beyond financing. The 2018 conference of the Platform for Collaboration on Tax1 highlighted this point, noting that tax structures affect many societal concerns including equality, investment and growth, women’s empowerment, environmental sustainability, and extraction of natural resources (World Bank, 2018[3]). All of these require special attention in fragile contexts.

Despite recognition of the transformative potential of domestic resource mobilisation, fragile contexts lag far behind other developing countries in their revenue raising capability. Using the World Bank’s definition of “fragile state”, recent research finds that the 12.1% tax-to-GDP ratio for low-income fragile states is an average of 4 percentage points lower than that of non-fragile peers, demonstrating that fragility has a significant impact on an economy’s capacity and willingness to raise tax revenue (Independent Evaluation Office, 2018, p. 11[4]).

The typical view is that a minimum of 15% of GDP in revenue is required to finance basic services (World Bank, 2018[5]). It is estimated that as many as 70% of fragile and conflict-affected situations had a tax-to-GDP ratio of under 15% in 2014 (IMF/World Bank, 2016[6]). In 2015, according to analysis undertaken for this report, 26 out of the 49 fragile contexts examined, or 53.1%, did not pass that threshold (Figure 7.1). On the assumption that the 9 contexts for which data are not available2 also would not pass this threshold – a highly likely possibility, considering most of these are extremely fragile – then it can be concluded that two-thirds of fragile contexts would have difficulty financing basic services from their own revenue.

These statistics should not obscure the fact that certain fragile contexts have made significant progress. For example, from 2010 to 2015, Mozambique, Republic of the Congo, Ethiopia and Tajikistan all improved their tax revenue as a percentage of GDP, by 6.15%, 4.57%, 4.54% and 4.46% respectively. Yet, pushing high levels of taxes on weak economies too quickly can have negative impacts and hamper economic growth, for example by discouraging private investment. Therefore, support is needed for better and more equitable tax systems rather than pursuing a myopic focus only on more tax collection (Long and Miller, 2017[7]).

In general, fragile situations are characterised by a narrow tax base that often relies on customs revenues and revenues from non-renewable natural resources rather than a balanced mix across all sectors of economic activity. Indeed, in fragile contexts with a high occurrence of non-renewable natural resources, royalties from these resources can make up a large share of the total revenues available.

7.2. Revenues and domestic spending

In fragile contexts, the amount of resources matters. How resources are spent and what they are spent on matter just as much. There is an assumption that more domestic revenue will equate to more spending on social services, and in general, the evidence base supports this (Long and Miller, 2017, p. 11[7]). However, as discussed in Trend Five (see Chapter 1), different governments also have different strategies for how to allocate their revenues and which sectors to support with the revenues. Where public services are absent or insufficient, people who can afford them often turn to private alternatives that not only are unregulated but also can increase inequalities (Mo Ibrahim Foundation, 2018, p. 2[11]). Figure 7.2 shows the variety of possible allocation strategies for sectoral spending as well as the challenges posed by the lack of complete and reliable data for all fragile contexts.

Overall, most fragile contexts allocate a large proportion of their revenues to debt and education; revenue allocation for the agricultural sector, social protection, health and defence is less uniform. Malawi and Mali spent more than 15% of their revenues in the agricultural sector in 2016. Angola, Honduras, Liberia and South Sudan barely budgeted 2% of their revenues in this sector. Spending on national defence in most fragile contexts is below 10% of total revenues. South Sudan is a striking exception, planning an exorbitant 80.41 % of its total revenues for national defence in 2016 while budgeting only 6.36% for education, 2.97 % for health and 0.62 % for social protection. It is worth noting, though, that the South Sudan Defence Forces are also a major employer, so a rapid reduction of the defence budget could be destabilising to household incomes. Allocation decisions, especially in fragile contexts, thus can have risky knock-on effects. Further, more balanced expenditure across key sectors is no guarantee against fragility: Mali, which planned a relatively uniform allocation among sectors, is in the extremely fragile category, as is South Sudan with its defence-heavy allocation of revenues.

Recent research finds that many African countries are having difficulties meeting their spending pledges in core areas such that an average fragile context would have to increase spending on education by about 20%, health by 50% and agriculture by more than 100% in order to meet commitments (ONE, 2017, p. 33[13]). This is not the case for all fragile contexts, as Ethiopia and Malawi, for example, both surpassed their commitments in spite of being fragile and low income (ONE, 2017, p. 34[13]). This shows that fragility, in and of itself, does not preclude investments in and progress on key social sectors if governments truly prioritise them and pertinent international support is provided.

International engagement can be structured to support better domestic resource mobilisation and budget execution capacity. Both are critically important. Technical support should focus on building capacity in revenue collection systems, including in customs, and in the public financial management of technical ministries to help these units spend their budget allocations. This support should apply to national ministries as well as decentralised authorities. In fragile contexts, capacity building for decentralised authorities is especially critical considering the positive effect that decentralisation can have on redressing real and perceived inequalities (UN/World Bank, 2018, p. 146[14]). As an example, since 1990, the number of such subnational administrative units in 25 African countries has increased by at least 20% and they must continue to be supported with the necessary capacity to succeed (Mo Ibrahim Foundation, 2018, p. 38[11]). Box 7.1 looks at several examples of support for capacity building for international taxation in fragile contexts.

Box 7.1. International tax standards and fragile contexts

Given its complexity and the significant capacity it requires for enforcement, international taxation is too often disregarded as a priority focus for fragile contexts. Rather, for fragile contexts, which often have to rely on a small number of large taxpayers, the emphasis is on ensuring simplicity and neutrality, and being able to work with a low administrative capacity and without the need for complex legislation (IMF, 2017[15]). These are not characteristics often associated with international taxation. Nevertheless, the wide availability of new tools and increasing support for the implementation of international tax standards are opening opportunities for fragile contexts. Several countries have identified potential benefits and prioritised implementation of parts of international best practice. Following are some examples:

Zimbabwe: Successfully using base erosion and profit shifting

Zimbabwe has sought technical assistance from the partnership of the African Tax Administration Forum (ATAF), the OECD and the World Bank Group (WBG) on issues related to base erosion and profit shifting (BEPS) since 2015. Like many countries and contexts affected by fragility, Zimbabwe had weak laws and limited capacity in tax administration. These left it facing significant challenges in terms of dealing with the complex tax planning strategies of some multinational enterprises to shift profits. For example, Zimbabwe had no transfer pricing documentation requirements and no rules enabling it to tax permanent establishments.

With the support of the ATAF/OECD/WBG programme over the past three years, Zimbabwe has successfully introduced stronger transfer pricing rules including legislation based on the BEPS outcomes but customised to meet the specific challenges facing Zimbabwe. These rules help the Zimbabwe Revenue Authority (ZIMRA) overcome its limited capacity, particularly to obtain information about such taxpayers and their transactions within a beneficial tax jurisdiction. The assistance has also helped ZIMRA to build its auditing capacity on international tax issues, resulting in a significant increase in tax revenue collected over the past two years.

Pakistan: The introduction of automatic exchange of information

Following revelations stemming from high-profile data leaks, Pakistan committed to joining the automatic exchange of information (AEOI) standard. AEOI offers developing countries great opportunities in the area of taxation because it provides access to information on their residents’ financial accounts held in other countries. It also is a challenge to such countries because it requires complex legislation, robust safeguards to keep the data they receive confidential and secure, and the capacity to implement an effective system to use the data received.

Pakistan has partnered with the United Kingdom and the Global Forum on Transparency and Exchange of Information for Tax Purposes to put in place confidentiality and data safeguards and other systems and organisational requirements needed to implement AEOI. Pakistan has completed all the legal, organisational and practical steps necessary to begin sending and receiving financial account information in September 2018. This effort created wider benefits across the whole tax system by providing information critical for anti-money laundering and anti-corruption purposes; supporting the digitalisation of the tax administration; and improving standards and practices related to confidentiality, data safeguards and data use, and risk profiling overall.

Liberia: Tax Inspectors Without Borders

Tax Inspectors Without Borders (TIWB) takes a learning-by-doing approach to capacity building through support for active audits of multinational enterprises. This approach has generated more than USD 328 million from its 33 programmes in 25 countries. In Liberia, TIWB is supporting the Natural Resources Tax Unit (NRTU), which is responsible for the mining, oil and gas, agriculture and forestry sectors and, as such, some of the largest companies in the country. The TIWB programme has provided a transfer pricing and extractives industry expert to work directly with the NRTU to build capacity to identify and then undertake audits. This approach to capacity building can have a significant impact in a short time by, in addition to building capacity, bringing in increased revenues from audits. The first assessments in the Liberia programme have been issued, with the potential for significant revenues.

Democratic Republic of the Congo: Revenue statistics

The African Union Commission, the African Tax Administration Forum and the OECD supported the inclusion of the Democratic Republic of the Congo (DRC) in the 2017 edition of Revenue Statistics in Africa (OECD/ATAF/AUC, 2017[16]). This has equipped the DRC with a tool that provides essential evidence to support reforms aimed at mobilising resources to finance public goods, services and infrastructure.

The process has contributed to better data collection and reporting systems, notably the collection of data on social security contributions for the first time. Internal co-operation between the revenue agencies in the DRC also has been improved including through the creation of a platform to report all the revenue streams collected by the general government, which were previously unavailable. The reporting changes have provided the DRC a set of reliable and detailed data comparable to data that is consistently available to other African countries.

Contributed by the Centre for Tax Policy and Administration, GRD, OECD

International support also can affect incentives that in turn affect spending allocations. If donors are investing large amounts of ODA in social sectors, for example, partner governments have less incentive to allocate their own budget resources in the same sectors. To avoid this pattern, donors could introduce a phased approach. For example, a donor might agree to invest heavily in health for a fixed number of years while building the absorption capacity of the partner’s health ministry and then agree with the government to reduce ODA in tandem with increased domestic spending on health.

As focus increasingly shifts to domestic revenue mobilisation as a key part of the development finance solution for fragile contexts, attention will need to be paid to the complex impact of higher revenues on the lives of average citizens. Taxes can be a double-edged sword, especially when they are not channelled into responsible social sector spending and demonstrable improvements in services. At worst, they can promote divisions in society if they are opaque or preferential (Long and Miller, 2017, p. 11[7]). Taxes also can reveal highly problematic elite bargains (Di John, 2010, p. 3[17]). As these become more visible and apparent, they may fuel grievances and perceptions of inequality. Caution is needed as well in economies that are predominantly informal to ensure that the tax burden does not rest unfairly on a relatively small middle class, since this could lead to frustration. Therefore, continued support will be needed to ensure that the push towards strengthening domestic resource mobilisation is accompanied by increased technical assistance, greater transparency, and civil society empowerment and capacity building so that it becomes more engaged in oversight and monitoring of fiscal accountability.

7.3. Natural resources

Natural resources can be a blessing in non-fragile contexts. But they tend to be a curse in situations of fragility, where poor governance and weak institutional capacities are pervasive. If managed properly, natural resources can potentially catalyse transformative change (African Development Bank, 2016[18]). Yet more often than not, they create opportunities for corruption, encourage elite capture, serve as a source of financing for armed conflict and decrease the overall incentives for governments to broaden their tax base. Since paying taxes is also a means for citizens to gain political representation, over-reliance on natural resource taxation also weakens the social contract between the state and its citizens (Crivelli and Gupta, 2014[19]) and is likely to have a negative impact on overall perceptions of state legitimacy. Figure 7.3, which presents total revenues from taxes and other revenues for 36 fragile contexts, shows that resource-rich countries such as South Sudan, Iraq and Equatorial Guinea stand out in terms of their reliance on revenues from natural resources.

From an economic perspective, dependency on natural resources also can lead to what is sometimes termed Dutch disease. This describes a situation in which exchange rates rise at the expense of investments in export sectors, such as manufacturing and services, which are generally associated with technological innovation and job creation. Where non-renewable, exhaustive natural resources – minerals in particular – are present, economic specialisation also exposes fragile contexts to the volatility of international commodity price cycles. It also increases their economic vulnerability, as exemplified by the fall in commodity prices after 2013. In Africa, which is home to 11 of the 20 resource-rich fragile contexts in the fragility framework, the effects of that drop in commodity prices contributed to a 44% decline in resource revenues and led to a 23.6% decrease of the total domestic revenue for the 2012-15 period (ONE, 2017, p. 11[13]).

Fragile contexts are especially vulnerable. Dependency on natural resources revenues leaves such economies exposed to poorly negotiated deals that benefit to an enormous degree international companies and third states while the people living in fragile contexts see only a small percentage of the true value of resources. Environmental risks may also increase if these deals do not require extraction and use of resources, including those in the so-called “blue economy”,3 to be managed sustainably.

Figure 7.4 shows the reliance on natural resource rents4 as a percentage of GDP and indicates that Liberia, Timor-Leste, Iraq and the Democratic Republic of the Congo are especially vulnerable to swings in commodity prices. This figure, when considered with Figure 7.3, also makes clear that some economies that rely heavily on natural resources are not reaping the benefits of revenues from these resources. A case in point is Liberia, where the reliance on natural resource rents as a percentage of GDP exceeds 40% and the percentage of non-tax revenues from natural resource revenues barely reaches 5%. Estimates for total natural resource revenues are necessarily lower than those for total natural resource rents. But cases like Liberia (and Mauritania) suggest that governments sometimes lack the resources and monitoring capacities necessary to effectively monitor mining activities, thus paving the way for international companies and third states to exploit natural resources without paying appropriate taxes.

In fragile situations threatened by resource depletion, and where the negative effects of reliance on natural resources coexist with a dysfunctional fiscal framework, economic diversification is essential to stabilise public finance, create incentives for foreign investment and build the foundations for economic sustainability (Ahmadov, 2012, p. 4[21]). A wealth of non-renewable natural resources, however, also may lull governments and the public into a false sense of economic security and make diversification seem less pressing. This can occur even though resource-rich countries will not automatically achieve sustainable growth or sustainable job creation; as many studies suggest, extractive industries generate relatively few jobs given their capital-intensive nature (UNCTAD, 2015, pp. 5,8[22]).

In many fragile contexts, even those with natural resources, the agricultural sector holds the key to unlock the transformational potential of their economies in the near to medium term. It also is a main contributor to GDP (Figure 7.5). In Africa, the agricultural sector employs as much as 70% of the workforce and agriculture also is the main economic activity of the more than 70% of Africans living in rural areas (World Bank, 2013, p. 14[23]). Africa has more than one-fourth of the world’s arable land (McKinsey & Company, 2010[24]). Yet, as recently as 2010, Thailand exported more food products than the entire sub-Saharan Africa region (World Bank, 2013, p. 14[23]). Some fragile contexts are not even producing enough for their own needs. In 2013, for instance, Liberia was importing 99% of its food needs, according to its government (Liberia Ministry of Commerce and Industry, 2013[25]). Its overreliance on imports led to a negative trade balance that reached a high of -161% of GDP in 2007 and imports still are needed to cover basic goods such as eggs, chicken and pork (USAID, 2015[26]).

Agriculture in many fragile contexts remains primarily an informal sector, however, so greater focus on this sector will not necessarily lead to higher tax-to-GDP ratios and could well lead to the opposite result (Addison and Levin, 2011[27]). If people living in fragile contexts are to feel the primary benefits of growth in the agricultural industry, their governments must retain control over more of the value chain as the sector develops, so that the profits do not only go to multinational agribusiness firms, for instance.

To promote growth, domestic revenues should be reinvested in productive sectors, including agriculture, rather than just basic services. Given population growth in Afghanistan, for example, the agricultural sector will need to grow by at least 6% per year to increase incomes and the living standard (World Bank, 2014[29]). Likewise, improving the agricultural system of sub-Saharan Africa will require as much as USD 50 billion in additional investment accompanied by increased access to financing and fundamental inputs such as seeds, fertilizer and water (McKinsey & Company, 2010[24]).

Economic diversification, therefore, should be a focus for donor support. This is especially relevant in fragile contexts that are rich in natural resources, where technical support can help implement economic diversification strategies and more effectively manage such resources. Yet in 2016, only 0.27% of total ODA to fragile contexts (USD 182.4 million) was disbursed for support to the mineral resources and mining sector. Just 51% (USD 93.5 million) of that relatively tiny amount of ODA specifically dealt with mineral or mining policies and administrative management.

Different contexts will pursue and achieve diversification differently. But as a general rule for economic development in fragile contexts, donor support needs to start at an early stage, focus on strengthening governance structures and institutions, invest in capacity building and functional regulatory frameworks, and contribute to the creation of a business-enabling environment to strengthen the private sector (OECD, 2011[30]; Asian Development Bank, 2016[31]). Given the many and diverse challenges facing these fragile contexts, donors also need to develop tailored approaches that build on a thorough understanding of the political and economic context while allowing diversification to happen at an appropriate pace. Economic diversification is not a quick process. But if it is targeted to the needs of the economy in fragile contexts, it will help build resilience and the foundations for sustainable economic growth and development.

7.4. Illicit financial flows

Illicit financial flows (IFFs) pose further challenges to the mobilisation of domestic revenues. More broadly, they are an obstacle to economic growth and development and to addressing fragility. IFFs are commonly defined as money illegally earned, transferred or used. In institutionally weak contexts, they tend to place severe strains on governance structures and public institutions and provide a breeding ground for criminal networks to flourish (OECD, 2018, p. 18[32]). As discussed in Trend Ten (see Chapter 1), IFFs also can feed instability, fuel corruption, and exacerbate the potential for conflict and violence depending on the particular type of flow and who profits from it.

In fragile contexts, IFFs represent a huge net outflow of capital and deprive governments of the resources necessary to provide public goods such as basic security, infrastructure, health and education. The size of illicit financial flows in fragile contexts is hotly contested, and the fact they are illicit makes it nearly impossible to arrive at one figure, but they are largely estimated to exceed inflows of aid and net FDI combined (OECD, 2018, p. 18[32]; OECD, 2014[33]). One research report estimated that IFFs cost developing and emerging economies – a category that includes many fragile contexts – approximately USD 7.8 trillion from 2004 to 2013 and USD 1.1 trillion in 2013 alone (Kar and Spanjers, 2015[34]). Illicit financial flows may be costing Africa, home to 35 of the 58 fragile contexts in the OECD fragility framework, an average of USD 50 billion per year (OECD, 2018, p. 13[32]). Illicit financial flows are particularly difficult to quantify in fragile settings, where they have a complex relationship with the broader political economy in these places (Box 7.2).

Box 7.2. Illicit financial flows and fragility

Illicit financial flows are a global problem. But their economic, social and stability effects are particularly marked in contexts that are highly vulnerable, rely on immobile or natural commodities, and are already grappling with chronic fragility and episodic conflict.

A recent OECD DAC report on illicit financial flows focused on the economy of illicit trade in West Africa. It found that the distinction between licit and illicit activities is often blurred and cited the lack of viable livelihood alternatives as one factor explaining the prevalence of illicit trade and individual involvement in criminal economies in West Africa and elsewhere (OECD, 2018, p. 117[32]).

Illegal activities often offer the essential forms of subsistence livelihoods for those with few viable opportunities in the formal sector, especially the poor. For example, whole borderland communities in the Sahel are dependent on illicit cross-border trade of fuel and commodities while rural communities may rely on illegal logging, poaching and forced labour. Activities like commodity smuggling, arms trafficking and even human smuggling may not carry the stigma of criminal behaviour in the eyes of the local population, who may develop a range of services to optimise the downstream benefits of these activities. This creates interdependencies at the local level. For instance, towns along major smuggling routes have developed a host of complementary services including the provision of accommodation, food and armed security for hire.

In addition to the illicit and informal economy, the informality of the financial system is a leading driver of illicit financial flows in the Sahel region. More than 80% of the population do not have access to a formal banking system, so most financial transactions are carried out in cash or through informal money transfer systems. These place significant volumes of transactions outside the reach of government, regulators and international trade measurement. Financial exclusion exacerbates the risk of money laundering and terrorist financing in the region, while also impeding the economic benefits derived from access to the banking system such as community empowerment or an increase of consumption and productive investment.

The complex interaction of illicit financial flows with licit and informal economies and local livelihoods, as well as their links to problems of financial exclusion, means that adopting solely security-based approaches to tackle illicit financial flows is likely to be ineffective. Indeed, such approaches will often serve to displace or exacerbate the problem rather than mitigate it.

Addressing illicit financial flows in contexts of fragility, where they are multi-dimensional and dynamic in nature, requires a nuanced understanding of local political, economic and social contexts and relationships. Any approach also needs a development perspective to avoid doing (more) harm.

Illicit financial flows are deeply intertwined with problems of development, frequently dovetailing with societal injustice or inequality and linked local to strategies of survival. It is important, then, to consider the context in which illicit activities take place and the degree of harm they generate. These will be reflected in the origins of the goods sourced; the networks or actors involved and incentives that drive them; and how their resulting illicit financial flows are earned and invested. Addressing these flows therefore requires the adoption of multisectoral policy approaches.

Contributed by the Governance for Development Unit, DCD, OECD

7.5. Informal economy

Donors tend to focus on all things illicit and especially on money laundering, tax evasion and international bribery (OECD, 2014[33]). But the informal sector also includes activities that are not per se illegal in their intention (OECD, 2018[32]) or that are not considered illegal in a specific socio-economic and cultural setting. As noted in the discussion of illicit flows in West Africa, the theoretical and regulatory distinction between illicit and licit activities is often blurred in fragile contexts, where the formal sector is underdeveloped and many people rely for their livelihoods on informal activities.

It is estimated that the informal sector in a typical developing country produces approximately 35% of GDP and employs 75% of the workforce (World Bank, 2016[35]). In a fragile context, the relative weight of the informal workforce often is higher (Figure 7.6). According to OECD calculations using data available for 30 of the 58 fragile contexts analysed in this report, informal employment on average is estimated at 82.5% of total employment. In Burkina Faso, for example, informal employment constituted 94.6% of total employment in 2014. In Tanzania, the proportion was 90.6%. In fragile contexts, then, the informal economy is the main economy and it may dwarf the formal economy (Schoofs, 2015, p. 3[36]). Box 7.3 explores this in more detail.

Box 7.3. The informal economy

The informal economy provides livelihoods for millions of people in developing countries and employs the great majority of the labour force in fragile contexts. But its role in economic development and resource mobilisation remains a subject of debate. Some workers, often those at the high-end segment of the informal labour market, may freely choose to work informally, finding that informal employment can support livelihoods and keep individuals and households out of extreme poverty. However, many workers are forced into informality due to a lack of formalised employment opportunities. The impacts of a large informal sector are felt at both the individual and societal levels and affect poverty, productivity and public finance (OECD, 2009[38]).

Although informal work may be the only way poorer people can access the labour market, informal workers usually face a broader array of risks than formal workers. Informal jobs in developing countries are often precarious and not covered by social protection. Women in informality are particularly vulnerable. They tend to be over-represented in low-quality jobs such as domestic workers, home-based workers or contributing family workers, which has implications for women’s earnings and their access to social protection and other benefits.

The exclusion of informal workers from labour-based insurance and other statutory schemes means that a variety of risks – among them illness, injury, maternity, disability, job loss and old age – are poorly covered or not covered at all. Assessing those risks is essential to fully capture the benefits to society that would come from the extension of social protection to the informal economy. Identifying appropriate modalities for adaptation and extension of social protection also requires such an assessment. OECD analysis shows that differences in household composition mean that a disproportionately large share of dependent family members, such as children and elderly relatives, live in informal households. This means that lack of proper social protection coverage affects not just informal workers but also a significantly larger population. Effort to extend social protection to informal workers should recognise the diversity within the informal economy, and especially differences in terms of potential eligibility and capacity to build up entitlements (OECD, forthcoming[39]).

High levels of informality also affect fiscal revenues. Formal direct taxation of households and businesses in the informal sector is challenging and often not cost-effective. However, the informal sector indirectly contributes to tax revenues through other taxes and links to the formal sector. In developing countries, governments tend to rely on indirect taxes such as value added tax on consumption, which has the advantage of not being subject to high compliance costs. Indirect taxation of informal businesses and households also occurs through labour and monetary payments outside of the formal tax system in many developing countries. Informal taxation systems are co-ordinated by public officials, although enforced socially rather than through the formal legal system. Empirical evidence from ten developing countries shows that informal taxation constitutes a substantial share of local public revenue, especially in rural areas (Olken and Singhal, 2011[40]). Estimates of formal taxes as a result may understate the true tax contribution of households and enterprises in the informal sector.

Contributed by the Development Centre, TD/SC, OECD

7.6. Small and medium-sized enterprises

The OECD defines small and medium-sized enterprises (SMEs) as “non-subsidiary, independent firms which employ fewer than a given number of employees” and “can be either formal or informal” (OECD, 2005[41]). The threshold number of employees varies considerably depending on the country where the definition is applied, but it usually denotes firms with fewer than 250 employees and includes micro-enterprises of just several employees. It is estimated that SMEs employ up to 90% of all workers in developing countries; the estimated number of SMEs in the world ranges from 365 million to 445 million (Page and Söderbom, 2012, p. 3[42]). SMEs have several comparative advantages in fragile contexts. They can be more flexible and less risk-averse. They can provide services in areas the government may not reach. They also provide jobs including to those whose skills might not be as useful to or recognised by larger companies.

Beyond these advantages, SMEs have the potential to support social cohesion and reconciliation by economically linking different groups. SME actors are potentially more invested in sustaining peace since they are connected to communities and directly affected by local instability (Hoffmann and Lange, 2016, p. 13[43]). Local businesses and entrepreneurs traditionally have not been recognised as peace actors. Increasingly, though, the vital role they can play in peacebuilding efforts and conflict prevention as well as economic growth is gaining credence.

Still, SME actors face multiple challenges that are particularly hard to overcome because of their size. Among these challenges are a lack of assets or asset destruction, a lack of infrastructure, macroeconomic instability, weak public institutions, complex land ownership rights, corruption, and security (Peschka, 2010, pp. 12-13[44]). SMEs also have trouble accessing credit. One report estimates the financing gap globally at between USD 2.1 trillion and USD 2.5 trillion, with formal micro-enterprises and informal SMEs accounting for more than 90% of the underserved enterprises (Stein, Ardic and Hommes, 2013, p. 7[45]). In Madagascar, for instance, donors are issuing guarantees to local banks to help them de-risk loans to SMEs. It is hoped that incentivising this lending creates a virtuous circle by helping the banks better understand the SME sector and thus building capacity and confidence for future lending.5

In 2016, USD 233.3 million (0.31%) of ODA in fragile contexts went to development of small and medium-sized enterprises through a variety of projects and funding sources. But there tends to be little co-ordination among donors (Page and Söderbom, 2012, p. 6[42]) Moreover, it can be complicated for both donors and governments to develop clear strategies to engage formal and informal SMEs, in part because these enterprises are so embedded in the social fabric and rely upon social identity groups and existing power configurations (Hoffmann and Lange, 2016, p. 48[43]).

While they may not easily fit into existing regulatory structures, the informal and SME sectors in fragile contexts represent considerable untapped, positive potential and they should be considered key assets in fragile contexts where external sources of finance are limited. Given the challenging operating environment in many fragile contexts, however, entrepreneurs and small businesses are frequently forced to focus only on economic survival. They rarely have the luxury to think about formalisation or expansion. Research in the three fragile countries of Afghanistan, Pakistan and South Sudan shows that businesses tended to develop strategies of resilience as opposed to growth in order to keep operating in these insecure and unpredictable environments (Hoffmann and Lange, 2016, p. 24[43]).

The traditional approach to informality was to figure out how to formalise it, often without appreciating the enterprises’ or entrepreneurs’ disincentives and lack of capacity for doing so. Greater effort is needed to identify and implement incentives so that incremental formalisation is attractive and leads to benefits such as access to new market opportunities and financial and non-financial services (Stein, Ardic and Hommes, 2013, p. 8[45]). In part, this will require donors to continue to adjust their support and not focus solely on the enabling environment and investment climate (Page and Söderbom, 2012, p. 5[42]). In addition, they should invest in understanding the specific context and constraints that actors face at all levels of the economy, and tailor interventions accordingly.

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Notes

← 1. The Platform is a joint effort of the OECD, International Monetary Fund, United Nations and World Bank Group. It was launched in April 2016.

← 2. These are Burundi, the Democratic People’s Republic of Korea, Eritrea, Iran, Nigeria, South Sudan, Syria, West Bank and Gaza Strip, and Yemen.

← 3. The World Bank defines the blue economy as the “sustainable use of ocean resources for economic growth, improved livelihoods and jobs, and ocean ecosystem health”. For more information and a useful infographic, see (World Bank, n.d.[45]), http://www.worldbank.org/en/news/infographic/2017/06/06/blue-economy.

← 4. Total natural resources rents are the sum of oil rents, natural gas rents, coal rents (hard and soft), mineral rents, and forest rents in both the private and public sectors. Amounts shown in Figure 7.4 are calculated by taking the difference between the total value of the natural resources extracted and the cost of the extraction. Natural resources rents are captured partly by the private companies. See (OECD/ATAF/AUC, 2017[13]).

← 5. This information is based on research the OECD conducted in Madagascar as part of ongoing Financing for Stability work. For further information, see (OECD, n.d.[47]).

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