The Political Economy of Fiscal Policy Efficiency: A Study on Developed, Developing and Least Developed Countries

THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY A STUDY ON DEVELOPED, DEVELOPING AND LEAST DEVELOPED COUNTRIES Mehmet Emre ÜNSAL Lyon 2025 THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY A STUDY ON DEVELOPED, DEVELOPING AND LEAST DEVELOPED COUNTRIES Mehmet Emre ÜNSAL Lyon 2025 The Political Economy of Fiscal Policy Efficiency: A Study on Developed, Developing and Least Developed Countries Author • Assoc. Prof. Dr. Mehmet Emre ÜNSAL • Orcid: 0000-0002-0777-1399 Cover Design • Motion Graphics Book Layout • Motion Graphics First Published • November 2025, Lyon e-ISBN: 978-2-38236-960-9 DOI: 10.5281/zenodo.17746155 copyright © 2025 by Livre de Lyon All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission from the Publisher. The author or authors of the relevant section are responsible for any copyright infringement that may occur due to the images and graphics used in the book. The editor or publisher does not assume responsibility in this regard. Publisher • Livre de Lyon Address • 37 rue marietton, 69009, Lyon France website • http://www.livredelyon.com e-mail • [email protected] I CONTENTS CHAPTER I. THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY ..................................................................... 1 Political Economy of Fiscal Policy .................................................... 3 Classical Approach .............................................................................6 Keynesian Approach .......................................................................... 9 Monetarist Approach ........................................................................ 11 New Classical Approach .................................................................. 14 New Keynesian Approach ................................................................17 Supply-Side Economics Approach ................................................... 20 Post Keynesian Approach ................................................................22 CHAPTER II. DEVELOPED COUNTRIES ........................................................... 25 Fiscal Policy in Developed Countries .............................................. 27 Government Expenditure in Developed Countries .......................... 29 Subsidies and Other Government Transfers in Developed Countries ........................................................................30 Income Taxation in Developed Countries ........................................ 32 Literature .......................................................................................... 33 CHAPTER III. DEVELOPING COUNTRIES ......................................................... 43 Fiscal Policy in Developing Countries ............................................. 45 Government Expenditure in Developing Countries ......................... 46 Subsidies and Other Government Transfers in Developing Countries.......................................................................48 Income Taxation in Developing Countries .......................................50 Literature .......................................................................................... 51 CHAPTER IV. LEAST DEVELOPED COUNTRIES . .............................. 61 Fiscal Policy in Least Developed Countries .................................... 63 Government Expenditure in Least Developed Countries ................. 65 Subsidies and Other Government Transfers in Least Developed Countries .......................................................................................... 67 Income Taxation in Least Developed Countries ..............................69 Literature .......................................................................................... 71 REFERENCES .......................................................................................................... 79 1 CHAPTER I THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY Political Economy Political economy analyses how political institutions, power structures, and strategies cumulatively shape economic outcomes, as well as how economic change, in turn, affects the set of feasible policies by feedback mechanisms that change coalitions and credibility. Markets and states are viewed as rule-based systems, or laws and norms, that allocate rights, limit discretion, and generate rents, so that economic growth, distribution, and stability depend on the robustness and flexibility, rather than technological features per se, of the rule systems (North, 1990). Rather than treating economic policies as the calculations of technocratic optimality, the approach views economic policies as an equilibrium game among voters, politicians, bureaucratic organizations, firms, and social groups faced with informational uncertainties and limited enforcement, so that institutional arrangements, or devices and mechanisms for commitment, monitoring, and punishment, are crucial to both positive and negative economic explanations (Acemoglu & Robinson, 2006). One strand, concerned with political competition, parties, and interest organizations, illustrates how preferences are translated into policy, demonstrating how election institutions influence whether governments provide public goods or targeted transfers and whether accountability moderates or enhances rentseeking by clientelism. Modelling lobbying and contributions captures how concentrated benefits and/or diffuse costs distort tariffs, contracts, and regulatory barriers, as well as how transparency, disclosure, and agenda control reforms can better align priorities without losing expertise, particularly when institutions securing oversight ease informational burdens (Persson & Tabellini, 2000). The approach developed regards capture as a predictable implication rather than an exception and explains policy resilience as repeated games, given that reputations, switching costs, and supermajoritarian veto powers impose a price 2   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY even if efficient reforms are at issue when a change is attempted (Grossman & Helpman, 2001). The fiscal arm of political economy emphasizes how constitutional structure, common pool problems, and time-inconsistency problems create biases with regard to the size, composition, and timing profiles of public spending, with partial legislatures and overlapping jurisdictions contributing to excessive spending on visible, localized activities and inadequate outlays for maintenance and investment. There exists analytic and empirical evidence that centralized budget procedures, with strong finance ministers, top-down aggregation sequences from aggregates to details, and multi-year expenditure programs, reduce budget deficits and enhance adjustment quality by internalizing externalities among claimants and hardening budgetary commitments over time relating to appropriations (Weingast, Shepsle, & Johnsen, 1981). Such budget institutions do so, not by applying austerity mechanically, but by reforming institutions to better structure negotiations so as to require transparent commitments ex ante, hence lowering election-period opportunistic re allocations, while heightening the credibility of medium-term fiscal policies that support private investment activities (Hallerberg & von Hagen, 1999). Monetary political economy is about credibility and expectations: once rational, forward-looking agents understand policymakers’ incentives, any commitment to a trade-off between inflation and unemployment will create an inflation bias with no employment solution unless institutions condition behaviour ex ante. Commitment devices, or rules, mandates, and reputations, link actions to simple, clear, and visible targets or reaction functions so that regular policy action can stabilize expectations and reduce risk premia, so that the normative standard switches from unprogrammatic activism to rule-like conduct, which preserves state contingent variability ex ante by announcing feedback functions to well-defined, observed states (Barro & Gordon, 1983). The contemporary vision implements this argument by involving explicit response functions, inflation targeting, or communication tactics that translate data into action in a predictable manner, consistent with coordinating agents’ incentives both in the monetary and fiscal institutions, as making explicit the conditions under which a benevolent policymaker will accommodate or resist shocks, respectively (Clarida, Galí, & Gertler, 1999). Developmental political economy specifies how institutional differences, varying in the quality of constraints on executives, an independent judge, and secure property rights, drive investment, structural transformation, and rent THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY   9 specify how coalitional patterns, credibility, and distributional incentives drive societies onto different trajectories, reducing classical worries about surplus and power to a set of grounded explanations about why similar perturbations imply distinct equilibria and why institutional change involves obvious, disputed, and path-dependent modifications to policy and politics (Acemoglu & Robinson, 2006). Keynesian Approach Keynesian approach addresses deviations in economic activity and employment as a problem of decentralized coordination, which can be facilitated by government institutions capable of managing aggregate uncertainty by correctly coordinating aggregate demand pressures. Fiscal and monetary policymakers are viewed as active, rather than passive, participants actively influencing private expectations. Consequently, the implementation process of their policies as they translate into economic outcomes. The term “Keynesian” rather refers to a set of commitments to a constitution, designed around a strategy to effectively manage uncertainty, market incompleteness, and nominal frictions, whereby the feasibility and necessity of policy action depend on institutional credibility, budgetary constraints over time, and politics of distributional concerns (Woodford, 2003). The debates revolving around the sustainability of debt and the welfare implications of a low real interest rate further reformulate the management of a countercyclical policy as a problem related to a condition involving the optimal choice between state-contingent decision rules, with a tension between insurance and prevention of moral hazard concerns (Blanchard, 2019). Microeconomic foundation, as a core component of the modern Keynesian approach, involves explicit frictions providing policy leverage: price adjustment costs, contracts that are staggered, or labour market imperfections, leading to a lack of neutrality in the short run and a space for welfare gains through stabilization even under rational expectations. When firms are characterized by either menu costs or complementarity, small nominal shock disturbances breed large real outcomes due to coordination problems, justifying an active role of stabilization via expectations and substitution over time (Mankiw, 1985). Additionally, efficiency wage theory and approaches characterized by near-rationality imply wage stickiness and involuntarily high unemployment, reinforcing the case for the social significance of costly demand disequilibria, as well as a proper handling of both price stability and employment smoothing 10   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY through institutional frameworks consistent with economic rules (Akerlof & Yellen, 1985). The tools and effects are state-dependent in this approach. The evidence shows that the magnitude and composition of fiscal multipliers depend on slacks, financial conditions, and the monetary policy framework, and identification strategies demonstrate exogenous government spending and tax shocks can crowd-in private sector spending when resources are idle and policy credibility matters. Narrative and institutional structural vector auto-regressions record the robust response of spending shocks to employment and output, focusing on an accommodative monetary policy framework with interest rates constrained (Blanchard & Perotti, 2002). Other evidence confirms that fiscal multipliers are found to be larger during recessions than expansions, or greater for government purchases than tax cuts when liquidity constraints are binding, so both composition and timing are critical margins to influence active fiscal policy designs (Auerbach & Gorodnichenko, 2012). Automatic stabilizers and institutions governing their operation are crucial to the Keynesian political economy agenda, as they offer insurance with a limited degree of discretion, both as regards procyclicism and opportunistic distortions. The evidence shows that the strong stabilizers, through progressive taxation, unemployment schemes, and transfer programs, reduce output variability and consumption uncertainty, as well as the political value attached to any given set of discretionary policies ex post, especially when the economy is depressed, hence the greater optimism among citizens (Fatás & Mihov, 2001). The institutional approach to managing the respective tools enhances their performance by establishing a medium-term anchor as a suggestive guide that supports fiscal sustainability, hence improving the efficacy and credibility (Debrun & Kumar, 2007). Keynesian approach is also a political endeavour related to ideas, coalitions, and legitimation as well. The rise of the paradigm, as a matter of history, represents the force of a policy vision that carries out full employment with price stability through macroeconomic management, whereby the expertise of governance is integrated into democratic institutions, alongside a renegotiation of the social contract established following World War II. Explanations of policy change point to how ideas about the economy reconfigure coalitions and routines, analysing how the policy vision supporting macroeconomic management gained ascendance, as well as how this vision was challenged by events involving inflation and globalization pressures (Hall, 1989). The recent backlash against THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY   11 austerity policies reignited this intellectual tradition by stressing ideas related to demand gaps, balance-sheet recessions, and distributional outcomes, resetting fiscal activism as a macroeconomic and financial fix rather than a technocratic adjustment procedure (Blyth, 2013). Finally, the open-economy and monetary-fiscal nexus represents the region where modern Keynesian political economy blends institutions and stabilization most directly. The rules governing interest rates, exchange rates, and fiscal policy define shock absorption and the feasibility of maintaining anchored expectations. Optimal policy becomes a question of how best to condition on feedback between inflation and economic activity, and policy instruments, to reduce welfare-distortive margins (Clarida, Galì, & Gertler, 1999). Forwardlooking models with nominal frictions demonstrate that commitments conveyed through transparent policy rules and state-contingent guidance can maintain both price and output stabilization, contingent on maintaining fiscal conduct consistent with intertemporal solvability, and preventing policies that could effectively violate commitments to monetary policy, reflecting the constitutionlike character of modern-day economic stabilization (Galì, 2015). Monetarist Approach Monetarist approach begins with the premise that cost-of-living inflation is a monetary phenomenon and goes on to consider how institutional frameworks can be designed to ensure that political forces do not create a tendency opposing price and productivity growth. A main concern with discretionary management, as an operational principle, is that elected governments and policymakers looking to next election cycles are tempted by potential gains from exploiting a policy menu involving short-term economic trade-offs, seigniorage financing, or election-cycle boosts; hence, predictable policies governing the money stock or a closely related operational proxy are seen as devices providing credibility to guide private expectations and, as a by-product, disciplining governments faced with future obligations to keep price-indexed distortions under control. The modern macroeconomic frameworks introduce notions of rational expectations and optimization, explicitly explaining why a lack of credibility toward governments’ economic policies results in channels through which an announced money supply feeds prices and wages, as opposed to an unannounced money supply, which, as an unforeseen shock, could have temporary realizations through various channels, explaining the link between the argument for a rule-based economic policy and the structure of economic 12   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY information, as well as related political calculations by time-inconsistent policymakers (Friedman & Schwartz, 1982). The quantitative models of business cycles, with market-clearing benchmarks, emphasize the monetarist philosophy that systematic and transparent policy, rather than occasional and active policy, is desirable, as active and volatile policy interventions are essentially changing rather than creating welfare, if agents are incorporated into the model (Lucas, 1987). Within the monetarist approach, the issue of rules versus discretion is central: agents will condition their behaviour on the policymaker’s incentives, so that the Phillips-curve trade-off in the short run to reduce unemployment by injecting money into the economy results in an inflation bias that doesn’t correspond to any improvement in employment. So that commitments are necessary to reduce the bias by constraining the policymaker effectively, independently of whether this involves controls based on aggregates, an exchange rate anchor, or a rule governing interest rate decisions that approximates quantity control when the demand for money is unstable (Barro & Gordon, 1983). A related literature suggests the appointment of a conservative central banker, an agent whose preferences are closer to those favouring low inflation rates than the median voter, to better align the policymaker’s incentives with the welfare of society (Rogoff, 1985). As money and fiscal policy are ultimately connected via the government’s budget constraint, fiscal dominance and the bounded effectiveness of central banks facing persistent deficits and bond market uncertainty about solvency are thus other key concerns of monetarist political economy as well. If a government forces the central bank to securitize debt by printing money, contractionary policies aimed at disinflating an economy could paradoxically generate selfreinforcing disequilibria as interest expenses increase and the present value of primary balances doesn’t change, making the political conditions for successful stabilization even harder and gravitating toward rule-based commitments binding both fiscal and monetary policies even closer (Sargent & Wallace, 1981). A political economic history approach to disinflations and regimes’ evolution in developed countries reveals that reductions in inflation are achieved when economic elites make a concerted commitment to fiscal-monetary reform packages but that mere changeovers involving central bank leadership are insufficient to change economic outcomes, as institutions, budget constraints, and expectations all matter for economic performance, including inflation rates (Sargent, 1999). THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY   13 Institutional design represents the operational backbone of the monetarist approach to political economics: independence, a clear mandate, and accountability arrangements that favour price stability enhance credibility and lower the incentive threat of funding fleeting political goals by shocktier inflationary expansions. Empirical evidence, comparing countries, shows central bank independence, both ideal and actual, to be associated with lower average rates of inflation without any apparent costs to economic growth, as predicted by the theory that depoliticized central bank operating policies reduce time-inconsistent policies (Cukierman, 1992). Other empirical researches, investigating broader political economies, show central banks, which are both more independent and operationally centralized, to achieve lower rates of inflation with less political pressure, as suggested by the argument that welldesigned institutions are instrumental toward attaining the rule-like quality desired by monetarist thinkers even if a strict growth rule could hardly be applied (Alesina & Summers, 1993). On policy instruments and evidence, monetarists have traditionally preferred targets for monetary aggregates to capitalize on their predictable correlation with nominal aggregates, but financial innovation and volatility of velocity have shifted focus toward rule-like policies involving interest rates, which still express the promise of predictability. Narrative evidence and structural VAR approaches to identification show that rule-like policies, announced and anticipated, are strongly preferable to discretion, both as regards explanations of inflationary dynamics, with credible disinflations conducted at lower costs in terms of output once the policy rule is well-known to the private sector (Blanchard & Perotti, 2002). The transition to inflation-targeting, which is by no means a monetarist course, expresses the same philosophy of rule and communication, involving announced targets, transparent response functions, and regular accountability, as a strategy to keep expectations anchored under conditions when aggregates are an unsound guide (Bernanke & Mishkin, 1997). From a political standpoint, monetarism is a constitutional approach: how to frame the game so that price stability is the Nash strategy of elected governments and their agencies, even when faced with tempting short-term shots. Consensus surveys of modern monetary policy claim that, despite differences over specifics, advanced countries seemed to move toward a vision whereby stable, predictable, and well-communicated policy, founded on a commitment to institutional independence and a well-defined objective, outweighed surprisedriven activism, with credibility acting largely through expectations rather than 14   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY actual, large, repeated adjustment of policy instruments (Goodfriend, 2007). Simple policy-guiding rules, expressing systematic reactions to price and output, flesh out the nominal anchor fixations implicit in monetarism, reforming an ideological commitment to restraint into a concrete signal legibly specified to elected policymakers and the public, even when they face a model uncertainty problem (Taylor, 1993). Finally, the open-economy aspect of monetarist political economy emphasizes how countries’ exchange rate arrangements, financial integration, and international debt facilitate or obstruct the viability of nominal anchoring and its credibility as a strategy for price-level management. The rule-based approach will have to consider the implications of balance-sheet problems and sudden stops, given that countries’ liabilities may be denominated in other currencies or their banks are dollarized, so that any attempted nominal anchor through monetary expansion will likely face challenges stemming from external financing pressures, making the anchor ultimately less viable if their fiscal environments are initially incongruent with their announced monetary rule commitments. The contingent but rule-guided approach to policy, well announced and institutionally supported by a coordinated fiscal strategy coupled with a viable monetary rule, is the solution offered by monetarism to achieve nominal anchoring with shock resilience, even as global investors continually price this nominal resilience as a constant threat (McCallum, 1988). Simple, openly operative feedback controls governing policy instruments guarantee a publicly verifiable commitment technology, enabling both voters and investors to check compliance with any deviations that may tend toward either inflationary finance or nominal instabilities (Taylor, 1993). New Classical Approach New classical approach involves restating macroeconomic dynamics and policy applications by applying both rational expectations and optimization, meaning that political implications are drawn from viewing the internalization of systematic policy by private agents as rendering systematic trends in real variables impossible. The implication is that the problem of economic stabilization, rather than being a question of suitable fine-tuning, rests instead with the problem of commitment and information. As both predicted actions are rendered irrelevant by the optimization model due to their inconsequence ex ante, while actions that are unforeseen are either temporary or deleterious once the rule being applied is fully understood by agents, meaning that the political THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY   15 economic implication is constitutive, revolving as it does around making sure that economic performance exhibits a degree of predictable durability, whereby governments are forced to face a price if they squander credibility by trading mere appearance for reality (Lucas, 1987). A historical approach to disinflations as a process vindicates this idea by indicating how a change succeeds if and as a sufficiently strong coalition supports rule-like action, as opposed to a mere leadership strategy founded on action rather than changing expectations regarding future systematic action (Sargent, 1999). One key foundation is the problem of rules versus discretion, modelled as a scenario in which forward-looking agents predict the policymaker’s incentive to maximize Phillips-curve trade-offs, resulting in an inflation bias unless institutions impose a commitment via precommitted actions. The solution, as proposed by the New Classical school, is to engineer a system, either reputation, contracts, or constitutions, that reduces policymakers’ time-inconsistent behaviour by making policy a rule or feedback function with well-understood contingencies to the private sector (Barro & Gordon, 1983). Complementary results in dynamic contracting theory generalize this implication, suggesting that successful policy involves making a promise that sequentially respects rational foresight, achieved by correlating strong institutions with punishments or statecontingent strategies that sustain cooperation among the fiscal, monetary, and private sectors (Chari & Kehoe, 1990). On the positive side, RBC models offer a general equilibrium framework whereby technology shocks and preference shocks, coupled with their transmission via both intertemporal substitution and capital accumulation, imply the absence of any room left for systematic demand management policies to enhance welfare, once expectations are accounted for. The role of political economy is incorporated via the fiscal wedge, as labour/leisure and saving/investment margins are changed by taxation schedules and other distortions, implying that institutional quality as specified by wedges affects the volatility, growth, and persistence characteristics of shocks (Kyland & Prescott, 1982). The traditional quantitative solution then uses preferences, technology, and institutions to calibrate the model so that the data’s moment structure is matched, implying that any institutional reform, specified as reduced distortions, predictable depreciation allowances, and a safe intertemporal budget, is essentially an exercise comparing equilibrium allocations specified by two differing, credibly enforced institutional alternatives (Cooley & Prescott, 1995). 16   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY Interactions between monetary and fiscal authorities are a central theme, as the government’s budget constraint imposes a link between money, debt, and credibility, implying that if fiscal policy drivers are prevalent, monetary policy attempts could remain inconclusive, as interest rates could offset solvency by demanding verification of public debt. The implication of the New Classical approach is institutional rather than technocratic, which argues that only institutions capable of disciplining both budgetary and money policies can effectively eliminate visions of inflationary financing, explaining the link between central bank independence reforms and reduced average inflation rates with adverse effects on economic growth being ambiguous or negligible at best (Sargent & Wallace, 1981). Investigations into various central bank statutes have confirmed this observation, implying that insulation, as a pressure relief valve, is an acceptable replacement for an impractical commitment strategy when faced with environments that could generate an inflation bias via discretion (Cukierman, 1992). Open-economy model extensions build credibility, analysing how nominal anchors and well-announced policy rules condition price-setting, wage bargaining, and portfolio decisions in financially integrated economies. Central to rational expectations versions of open-economy models, a policy rule functions as a communication channel, as by correlating a welldefined state of the world with a specified setting of the policy instrument in a predictable manner, policy reduces uncertainty and synchronizes private sector intertemporal decisions with macroeconomic stabilization, assuming fiscal support and super wisdom are consistent with the announced anchor (Obstfeld & Rogoff, 1996). The modern tradition on systematic policy, often conducted through transparent reaction functions and explicit communication, puts the New Classical intuition about decision rule-like behaviour into operation even if the policy instrument is an interest rate, instead of a monetary aggregates target with credibility accomplishing the major part of macroeconomic stabilization through expectations channels (Clarida, Galí, & Gertler, 1999). Methodologically, the New Classical approach turn elevates micro foundations, calibration, and general dynamic equilibrium as benchmarks for meaningful policy analysis, as any welfare-calibrated results should be consistent with agents’ intertemporal budget constraints and five-period expectations. Relative to statistical-based reduced-form methodologies, this approach asserts the necessity of Lucas critique frameworks, whereby institutional change THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY   17 analysis should be detached from the critique, as a prerequisite to generate meaningful policy opposites (Prescott, 1986). The position, as a matter of empirical evidence, has been instrumental in paving the way for hybrid approaches to economic evaluation, as a calibrated model structure combined with a prescription for shocks, differentiate between datasets characterized by policy rules or exogenous shocks, as a prescription toward understanding the role of credibility as opposed to activism (Hansen & Heckman, 1996). New Keynesian Approach New Keynesian approach grounds macroeconomic stabilization on explicit micro foundations: imperfect competition, nominal frictions, and forward looking, so that aggregates are a consequence of pricing frictions and incomplete risk sharing rather than disequilibrium. When firms price infrequently and wages are staggered, a demand shock yields an inefficient output and employment gap, and a proper policy rule can reduce this by influencing expectations about future income, prices, and interest rates. Here, the state is no longer a deus ex machina, a mysterious force imposing order out of chaos, but an institution governed by credibility and communication, results depend on the quality of policymakers’ transformation of states into instrument decisions, and whether economic agents accept this transformation as they make their spend, hire, and invest decisions. The political economy problem, therefore, is a constitutional one, delegating mandates, accountability, and procedures guaranteeing strong rulelike behaviour against uncertainty, while retaining enough state dependency to account for the frictions and informational constraints inherent in the data (Clarida, Galí, & Gertler, 1999). The modern solution embeds this mandate as an optimization problem subject to a commitment and an implementability constraint, with expectations management providing the crucial stabilizing channel if institutions credibly link decisions to welfare-relevant margins (Woodford, 2003). Micro foundations impose the normative bite of this program. The price stalls and information frictions generate wedges between private and social marginal rates of substitution, so a rule consistent with a predictable policy that minimizes a quadratic loss in both inflation and output gaps can improve welfare even if agents are rational and markets are competitive. When information spreads slowly, price setters respond to news with a delay and a nod, leading to persistence in both price and output, which highlights the gains from high-quality, systematic, and guided strategies. Such mechanisms imply distributional implications, as a 18   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY set of prices and wages adjusts faster than others, meaning that political cohorts may want to influence the pace and composition of the adjustment, particularly if debt, contracts, and nominal aggregates are mismatched. The institutional problem of an integrated New Keynesian approach is, therefore, to architect policy rules and communication architectures that coordinate decentralized decisions according to the macroeconomic provisioning, even if attention, contracts, and balance sheets are diverse (Mankiw & Reis, 2002). From this perspective, central bank transparency, projections, and policy reaction functions are substantive rather than ancillary institutions that fill informational frictions and anchor expectations around the desired trajectory of actual economic series and price levels (Galí, 2015). Credibility and time consistency are still at the core, but the solution now leans toward explicit reaction functions and inflation targeting, rather than fixed rules for money growth. The political economy puzzle is how the solution can be institutionalized as a democratic delegation to an independent, goal-oriented authority operating with well-specified goals and ex post accountability. So that, short-term gains are resisted, consistent with democratic values rather than longterm sovereignty being compromised. Theory illustrates how a conservative authority operating according to a specified, or announced, intertemporal loss function will allow a commitment strategy under uncertainty to replicate its results, assuming consistent communication and a fiscal policy that supports solvency or doesn’t weaken the announcement to achieve price stability (Rogoff, 1985). In empiric and operational terms, by expressing a commitment through estimated or announced functions and ranges, the so-called consensus formula captures this equilibrium between credibility and flexibility, translating an abstract commitment into a procedure traceable by the public and by legislators (Clarida, Galí, & Gertler, 1999). Fiscal policy appears in a New Keynesian approach both as a stabilizer and as a constraint on the promise to monetize future government liabilities. Under nominal frictions and occasional lower bounds to policy interest rates, government spending and targeted transfers have multipliers greater than one in the presence of high unemployment, financial frictions, or monetary accommodation, making their composition and timing decisions of prime political significance, entering policymakers’ welfare calculations as first-order decisions. Narrative and switching estimation strategies show identification implying institutions that facilitate speedy fiscal stimulation reduce output deviations and risks of hysteresises (Auerbach & Gorodnichenko, 2012). When 25 CHAPTER II DEVELOPED COUNTRIES Developed Countries Developed countries’ strong per capita earnings are accompanied by substantial progress on the health, education, and living standard fronts, but it is the simultaneous development of capabilities, namely human capital, infrastructure, administration, and innovative enterprises, within a stable macro-institutional context, which defines these nations, rather than income levels per se. The use of composite indicators following life expectancy, levels of education achieved, enables a multidimensional assessment of these areas, facilitating the distinction between structural capabilities versus cyclical prosperity, particularly examined within the context of resilience to disturbances, as well as inclusivity of growth (UNDP, 2023). The quality of institutions is a first-order basis of this performance context. In a setting where property rights are protected, judges are stable, so too is the public administration, lower transaction costs result, as do expanded planning horizons, making long-range contracting in value chains possible, while private investment gets crowded in. The effects of these institutional strengths compound, creating a hold on expectations, so even risk premia decrease, opening a larger feasible set of policies, starting from stabilization policies being counter-cyclical, until the formulation of missiondriven industry policies. Meanwhile, a degraded quality of institutions increases uncertainty, so it unravels markets, reducing the formation of capital as well as innovation especially at a time of high demands on adaptability (North, 1990). In the frontier, the rate of growth becomes relatively insensitive to the augmentation of the supply of labour and capital, as it is increasingly driven by idea production, which is a non-rival good, potentially increasing the productivity of complementary inputs. This explains the emphasis on research universities, public investment informed by a set of missions, as well as higherorder capability factors like managerial talent and data management, as well as the rise of intangible inputs like software, algorithms, organizational capital, a phenomenon well-articulated in the context of developed industries, even 26   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY within mature industries (Romer, 1990). The advanced economy establishes a set of networks between laboratories, start-ups, established firms, and investors, where standards facilitate idea scaling over borders. The social state has a macrocritical, rather than a simple redistributive, role. By pooling risks throughout the life cycle and in response to shocks, progressive tax-benefits systems elevate the floor below household incomes, more importantly, serve as automatic stabilizers, bolstering support as incomes decline, without the lag associated with newly enacted laws (Auerbach & Feenberg, 2000). Macroeconomic frameworks in developed countries also coordinate credible rule-of-law-based monetary policies along with the ability to conduct counter-cyclical fiscal policies with outcomes being state-contingent, in that in the context of slack in the economy along with nominal interest rates being near lower bounds in effect, the scope for discretion in public spending holds the potential for utilizing multipliers along with crowding in from the private sector mainly through improvements in rates of utilization (Blanchard & Leigh, 2013). The challenge in these policies is mainly embedded in sequencing, focusing on a smooth transition from a stabilization role to supporting economic growth, finally culminating in consolidation, while maintaining market credibility. Implementation capability is as essential as strategy in this regard, because cumulation of timelines, quality of procurement, as well as investment choice could mean the difference between promises of a boost from a stimulus package. In addition to these strengths, however, distributional-structural challenges have deepened. Skill-biased technological change, asset price cycles, and housing gaps in high-productivity cities have all contributed to increases in both market income inequality and wealth inequality, while demographic shifts have brought about heavier public expenditures on pensions and health care. Thus, achieving dynamism while dealing with inequality requires taxation-benefits systems that continue to be progressive and proficient, competition policy regimes continued to maintain markets as contestable, especially in data-intensive, knowledgeplatform areas, as well as housing and skill policies aimed at revitalizing geographical occupational mobility (Piketty, 2014). The climate challenge extends an investment agenda with a temporal component concerning clean energy, secure grids, storage, and a low-carbon industrial base to require credible price signals and the notion of a just transition supporting the agenda, while credibility reduces uncertainty premia, bringing in the level of private investment required (Stern, 2007). A high degree of networking among many of these investments makes coordination problems DEVELOPED COUNTRIES   27 very significant, such as requiring standards to be mutually compatible, supply chains to be diversified while maintaining efficiency, along with local permitting in line with macro-economic ambitions. In such a context, the agenda about industrial policy today involves crowding-in investment while maintaining competition and resisting cross-border subsidy races. Turning to the future, frontier success will depend on three interconnected elements: enhancing long-term productivity levels through science, infrastructure, and skill development; rebalancing the social contract to insure against longer life cycles and more volatile job careers, maintaining a strong tax base despite bases of profit-shifting and new income sources; and building state capacity so as to secure strategy implementation in areas such as permitting, procurement, data, and program evaluation. Countries choosing institutional flexibility within a legitimate order would have a higher chance of transforming technological progress and decarbonization into common benefits, as well as maintaining a high degree of international reputation in a fragmented world order (Andrews, Pritchett & Woolcock, 2017). Fiscal Policy in Developed Countries The three traditional roles of fiscal policy in developed countries are those of stabilization, allocation, and distribution, but recent approaches extend beyond the three-fold sphere to cover others, including credibility, long-term investment, and disaster risk resilience. The postwar macroeconomic order had governments realize the role of countercyclical policies in compensating the lack of demand without undermining long-term sustainability, on the condition that the budget be connected with the social rate of return on public capital. The current budgeting priorities reflect the same notion of reconciling the short run with the long run value creation (Musgrave & Musgrave, 1989). A defining feature of developed countries is the magnitude of their automatic stabilizers, consisting of progressive income taxes, unemployment benefits, and social benefits, which grow automatically in periods of weak activity, thereby insulating the disposable income effect and the aggregation demand without delay. The system works continuously, implying reduced implementation delay, reduced output volatility, and protection against possible labour market scarring due to its effect on stabilizing the consumption of liquidityconstrained households, apart from its effect on improving policy credibility by constraining discretionary treatment at the most political moments (Auerbach & Feenberg, 2000). 28   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY There is an increasing focus on rules on behaviour, or medium-horizon adjustment rules relating to how the primary deficit will react to the growth of debt, instead of focusing on deficit levels that may be pro-cyclical rules. The markets will provide rewards for adjustment strategies that promote growthinvesting but with dedication to future adjustment, especially if the interest growth differential is small, with possible adverse shocks. This implies the inclusion of contingent clauses, debt anchors, or the provision of escape clauses that provide room for stabilization, but with the long-run course on the correct track (Bohn, 1998). Empirical estimates show that the multipliers are statedependent, increasing in periods of recession, financial distress on monetary policy. In these settings, transfer payments, employment support, or investment with high shovel readiness are able to crowd in private spending, but the same policies in boom periods have weak or crowding-out effects on private spending. In view of the asymmetry, the optimal policy in periods of severe recession is to be timely, target, and time-bound (Auerbach & Gorodnichenko 2012). The distributional features of consolidation episodes’ design and arrangement are particularly important. Tax-driven consolidation, implemented over time, especially in a supportive monetary environment, has been found to be associated with smaller negative output effects than sudden spending reductions, while large, unexpected taxes can be very contractionary, particularly if they affect confidence or increase the user cost of capital. A trade-off, in this case, would be involved. This would be between speed, composition, and credibility, influencing expectations, as well as the real economy (Romer & Romer, 2010). Fiscal policies, specifically those financed through deficits, can be particularly effective in a scenario where economic actors expect the central bank to follow a non-expansionary policy, such as maintaining interest rates low until the economy is unable to generate further improvements, thereby absorbing the slack, or until inflation returns to target. In such regimes, the values of the multipliers can be higher than one, thereby supplementing a limited economy through strategic public investment expenditures (Christiano, Eichenbaum, & Rebelo, 2011). Looking ahead, the dual agendas of green transition and economic resilience recast the budgetary order to encompass high multiplier expenditures related to the vision of the future in the areas of low-carbon energy sources, climate-proof electricity grids, energy-efficient building renovations, low-carbon industries, and climate adaptability. Public investment funds in combination with credible carbon pricing instruments effectively mobilize finance on the vast scale, while DEVELOPED COUNTRIES   29 labour and regional policies make the transition just. The implementation capacity, including authorizations, public procurement, and project delivery, can become the bottleneck, so as much attention goes to institutional changes to make investment spendable as goes to headline budget commitments (Hepburn et al., 2020). Government Expenditure in Developed Countries In developed nations, public expenditure performs the traditional role of allocation, distribution, and stabilization, but the modern pattern involves a complex interplay of social-welfare commitments, capital accumulation, and macro-economic stabilization risks, as it is embedded in a set of strong budget institutions on a long-term horizon (Musgrave & Musgrave, 1989). In essence, a developed fiscal state translates a wide tax base into a large budget envelope on a multi-year basis, which funds universal services, public goods, and macroeconomic stabilization, thereby creating a self-reinforcing cycle between state capacity, investment, and social cohesion. Spending on human capital provides a foundation for long-term productivity trends because it increases the quality of labour, fuels innovation systems, and enables adjustments to technological change; payoff is achieved via enhanced cognitive abilities, improved allocation between firms and workers, and mutually supporting adoption of information and organizational technologies (Hanushek & Woessmann, 2012). The policy agenda, consequently, emphasizes quality-driven reforms, starting from curriculum quality, accountability, and catch-up interventions in education, while health systems, too, shift their emphasis from cure-focused spending to prevention and value-driven purchasing. Public investment is the investment frontier facing growth, where transport infrastructure, connectivity, and energy networks unblock constraints, lower trade costs, and leverage additional investment; more specifically, the total benefits rely on high quality in project screens, budgeting for life-cycle costs, and a procurement process consistent with maintaining competition transparency (Bom & Lighthart, 2014). In a setting where infrastructure investment involves lumpy, high-tech networks, coordination problems could be pervasive, so effective public finance management systems matter as much as investment amounts. Regarding the stabilization cushion, the expenditure component functions as an automatic stabilizer because of entitlement programs and unemployment insurance, both of which increase as economic activity declines, 30   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY reducing consumption, without the lag associated with newly enacted policies (Auerbach & Feenberg, 2000). During severe recessions, discretionary spending in the form of wage supports, transfers, and public infrastructure, known as shovel-ready projects, can be enacted to accompany automatic stabilizers, particularly if monetary policy is not effective. The efficiency of expenditure has always remained a challenge, driving a more results-driven budgetary approach, ex-ante assessment, and ex-post assessment, thereby reducing white elephant expenditure and seepage; crosscountry proof demonstrates that more investments are transformed into actual capital in countries where the procurement process, budgetary processes, and project execution are stronger (Dabla-Norris, Brumby, Kyobe, Mills, & Papageorgiou, 2012). Another frontier could be climate change and the energy transformation, where integrating green public expenditure, resilience expenditure, and expenditures supporting affected workers and regions with credible price signals becomes necessary to attract private finance; because many benefits are global in nature, while costs are local, public expenditure design can make a difference between sustaining public legitimacy over long-term transformations, such as a thirty-year transformation, as it did in the UK’s climate transformation (Stern, 2007). In this case, budgetary mechanisms supporting industrial policies along with infrastructure investment pipes become as important as the total fiscal stance. Subsidies and Other Government Transfers in Developed Countries In developed countries, the roles of subsidies and transfers go beyond the safety net, having a central organizing function in relation to risk-sharing arrangements throughout the life-cycle, maintaining aggregate demand, as well as setting incentives concerning education, labour, and investment. The transfers system plays a crucial role in the contemporary welfare state, as opposed to being a safety net (Barr, 2012). The design of the programs determines consumption smoothing within households, labour management within corporations, as well as transforming growth into well-being within societies. The typology of transfers includes social insurance benefits, near-universal in-kind benefits conditional on income levels, and means-tested cash and family assistance benefits, all of which cover different risks but cumulatively reduce the disconnect between market and disposable incomes. Cross-country evidence finds a huge DEVELOPED COUNTRIES   31 difference in inequality levels of post-tax inequality, explained largely by the level of generosity of such transfers across developed countries (Immervoll & Richardson, 2011). From a macroeconomic perspective, the transfers act as automatic stabilizers, increasing as incomes decline and decreasing as recovery takes hold, thus helping to stabilize demand without the lag associated with discretionary policy. This helps to smooth output fluctuations, as it is continuous and governed by a set of rules, making it helpful in building credibility without falling into ad hoc bargaining, particularly in periods of crises, as it is endogenous to the cycle (Auerbach & Feenberg, 2000). Producer-specific subsidies, especially those associated with agriculture and energy, have purposes such as income stabilization, regional cohesion, and strategic security, but can result in distortions, negative externalities, and distributional leakage, especially to more wealthy producers. The political sustainability of such policies, as well as a movement towards decoupled and greener instruments, has long been a topic of research for comparison analysts (Anderson, 2009). The trade-offs between design involve universalism versus targeting, where a targeted approach results in a savings of budgetary funds, though it could be hampered by complexities, stigma, and low rates of take-up, especially where information costs are high, while a universal approach results in a higher budgetary outlay, though it increases take-up (Currie, 2006). The trade-off along this consideration requires judgments on horizontal equity, labour supply incentives, as well as budgetary expenditures. Innovation-focused transfers and subsidies, R&D tax credits, matching grants, and mission programs are intended to address under-investment driven by knowledge spill overs and coordination problems; the modern toolkit promotes progressive experimentation, contestable entry, and sunset clauses to facilitate learning while precluding the creation of a rigid resource advantage or weakening competition as a creative motor (Rodrik, 2004). The impact credibility of these tools hinges on transparency. Looking ahead, the pressures of aging population, climate transition, and non-standard work arrangements are expected to call for the coverage of the additional risks by the transfer system in a financially sustainable way. Extending from child benefits-social pensions to more transformative income floors faces political and economic feasibility conditions based on credible means of finance, progressive claw-backs, especially for higher-income families, as well as high-quality evaluations incorporated in designing the scheme (Van Parijs & Vanderborght, 2017). 32   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY Income Taxation in Developed Countries The three interacting functions of income taxes in developed countries are generating a substantial, stable revenue, redistributing market income from one life cycle to another, as well as supporting aggregate demand. Within such a system, common bases, progressive rates, as well as strong third-party reporting, support easy compliance costs and low levels of evasion. Taking this perspective, both personal as well as corporate taxes can be considered complementary, rather than alternatives, as both withholding at source as well as returns can make administration feasible (Slemrod & Bakija, 2008). The basis for the norms is the modern optimal tax tradition, where rates are set as a balance between equity and efficiency, taking into account the fact that statutory rates affect labour supply, avoidance, and migration. The optimal systems thus entail progressive rates combined with credits at the bottom, where labour effects are maximal (Diamond & Saez, 2011). Redistributive performance is driven by the interaction of progressive taxation rates, taxation credits, and the transfer system. Refundable credits contribute to higher participation, while benefits for children and housing affect life-cycle distributions of disposable incomes, thereby reducing inequality in the post-tax distribution despite the rise in pre-tax inequality because of technology shifts and globalization forces, as noted in Atkinson (2015). Fine-tuning of phase-in/phase-out features is essential in optimal incentive design. The corporate income taxation faces special challenges in high-income economies. These include intangible-driven businesses, intra-group financing, as well as the prominence of low-tax subsidiaries, pushing towards profit-shifting behaviours. Even in situations where economic activities are firmly embedded, discrepancies at a macro level, showing variances between the treatment of profits versus labour, serve as a pointer to the degree of such activities (Tørsløv, Wier, & Zucman, 2018). Because cross-border defences are not particularly robust, international coordination has become an integral tool of income-tax architecture. By forming a minimum tax structure and a formulary feature, a floor can be set for the tax rates, thereby capping benefits from paper profits. In fact, a straightforward, rulesdriven approach has gained acceptance in order to avoid complexity, particularly in smaller as well as larger administrations (Devereux, Vella, & Wardell-Burrus, 2020. The credibility of such systems requires well-defined regimes, strong safe havens, as well as dispute settlement mechanisms. Administrative capacity is a large explanation for cross-country disparities in progressivity achieved. DEVELOPED COUNTRIES   33 A majority of individual income remains difficult to avoid, while individual accounts of capital income as well as self-employed income have significantly higher levels of misrepresentation without electronic evidence. Administrative capacity provides a higher ratio of progressivity achieved per tax euro than large-scale statutory reforms. (Kleven et al., 2011). Therefore, the design features include extension of the basis-broadening touch, high erosion preferences, as well as comprehensive capital income taxation. The dual income taxation systems, together with progressive taxes on labor rates coupled with a flat and uniform capital tax rate, attempt to lower arbitrage discrepancies by organizing higher capital than labor mobility (Sørensen, 2005). In implementation, these systems entail stronger anti avoidance rules in conjunction with simplified, more neutral tax treatment of dividends, interest, as well as capital gains. The future brings a host of challenges, ranging from digitalization and the rise of the platform economy, extending the frontier of third-party reporting, to an ageing population and the need to achieve a climate transition, making high-quality revenue a high priority while sustaining a minimum level of efficiency. Systematic reviews have found well-designed bases, combined with grants and consumption taxes, can bring in significant revenue at much lower cost than complicated rates of tax and a proliferation of tax expenditures (Mirrlees et al., 2011). The challenge of strategy is implementation. Literature The main objective of Landau (1985) is to investigate the relationship between government expenditure and economic development in developed nations over a long period of time since the end of the Second World War. The question posed by Landau is whether the growing importance of the public sector might perhaps be a factor in the apparent deceleration of economic performance. In contrast to research focusing on the public sector as a whole, the research examines individual elements, namely consumption, investment, and transferred expenditures, to establish the individual impact on economic development. The research question falls within a broader theoretical foundation, which contrasts the absolute inefficiency of government production with the role of state investment in industries where social returns are high, such as the education and infrastructure sectors. The approach to research design incorporates crosssectional as well as time-series elements within a host of developed countries. 34   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY The approach utilized within the research incorporates a number of econometric models, such as ordinary least squares as well as instrumental variable equations, correcting for both heteroscedasticity as well as simultaneity. The information gathered within the research is derived largely from the United Nations-World Bank International Comparison Program as well as the OECD, making it more comparable. The research has incorporated a model, which can trace economic growth trends based on government spending as a share of economic output, investment, education, changes in the terms of trade, as well as structural differences. Specifically, in relation to total government spending, it has differentiated the impact of both transfers as well as public investment. The results suggested a negative relationship between total public expenditure and per capita income growth. The relationship between government consumption expenditure, investment, and public consumption is particularly negative, while the impact of transfer payments remains less negative or even positive. By considering not only the amount of spending but also the composition of the same, the study allows for the analysis of the link that exists between fiscal policy and economic growth. Despite the fact that the study does not present a conclusive outcome, it presents enough indication of the direction of the link through the use of the estimation of the variable with the lag. Its importance presents one of the greatest contributions towards the empirical analysis of the impact of the increase in the public sector on the growth of the economy. Its relevance also stands in the discussion on the importance of the state in the control of the economic growth. The aim of the Dudzevičiūtė et al. (2018) is the provision of a more refined, understanding of the relationship between government expenditure and economic growth in the countries belonging to the European Union over a period of twenty years. The research is based on the theoretical rivalry between the Keynesian approach and the Wagnerian approach, both of which have radically differing views on the relationship between expenditure levels on one hand and measures of economic growth on the other. The research acknowledges the fact that the relationship between the role of fiscal policies in macroeconomic performance is a complex issue, as it has been noted that government expenditure can be both a cause for economic growth as well as a barrier to it, depending on a host of factors. The study concentrates on the EU because it presents a common yardstick for the regulation of fiscal policies. To achieve the research’s goals, the approach used in the research is the systematic approach. Firstly, the research will apply the use of descriptive statistics in identifying the trends in government DEVELOPED COUNTRIES   41 the need for balanced diversified tax systems, differentiated according to the realities of modern economics. Alinaghi & Reed (2021) integrate the vast but sometimes contradictory literature on the relationship between taxation and economic growth in the OECD economies. A number of empirical studies have attempted to measure the relationship between taxes on the GDP rate, but discrepancies brought about by differences in model specifications, datasets, and incorporation of government budget constraints have generated highly varied outcomes. The objective of the authors, therefore, is to resolve the discrepancies by using the meta-analysis approach to analyse close to a thousand findings on the tax effect from the literature. The article aims to assist the policymaker in determining the circumstances under which taxation has a certain effect on economic performance. The approach entails building a large dataset using tax effect estimations from a total of forty-nine empirical studies. The tax effect estimations are grouped into three categories depending on their expected net effects on economic growth, namely negative, ambiguous, or positive fiscal policies. The researchers make use of weighted least squares estimation techniques, both fixed-effects as well as random effects, to derive robust estimates for the average tax effects. Another approach considered by the researchers to correct for publication bias is the use of statistical methods such as the funnel asymmetry test, as well as adjustments for positive biases in favour of negative findings. Variables associated with regional classifications, research design, taxation, as well as economic systems have been considered to account for heterogeneity within the empirical studies. The results indicate that the relationship between taxes and economic growth varies greatly based on the use of tax revenue. If taxes are spent on unproductive expenditures, such as the cost of paying taxes, it would lead to a negative relationship between taxes and economic growth. On the contrary, taxes spent on more productive expenditures, such as investment in infrastructure, human capital, and research, would positively impact economic growth. The results also indicate evidence of publication bias, which favours the negative relationship between taxes and economic growth. Publication bias has, however, not contributed significantly to affect the findings from the meta-regression. The results confirm that taxation systems affect economic growth. The originality of this article resides in a comprehensive approach it applies to integrating inconsistent results from the literature on the relationship between taxes and growth. In fact, the fact that the authors consider only OECD countries allows for comparison between studies, along with consideration of a broad set of both fiscal and economic conditions. 42   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY Moreover, combining a meta-regression approach with a comprehensive categorization of different types of fiscal policies allows a more refined view on interactions between growth and taxes. In addition, the transparency of the research, supported by making available all data as well as the criteria applied for their coding, increases credibility as well as usefulness of research. The paper has both theoretical and empirical significance, adding to the discussion on a relationship between taxation and economic growth. 43 CHAPTER III DEVELOPING COUNTRIES Developing Countries Developing countries have diverse political economies, partial transformation of industry, which has large employment shares in agriculture and services, as well as high sensitivity to risks stemming from terms of trade, export diversity, and financial systems. They also tend to have binding bottlenecks in state capacity, contract enforcement, provision of public goods, which limit investments by reducing labour and capital movement into higher-productivity sectors, in a manner in which economic development itself is impelled as much by institutional transformation and state capacity as by accumulating factors (Acemoglu, Johnson, & Robinson, 2001). As such, as an analytical shortcut, it is useful to think of the category of a developing country as conceptually distinct from a threshold level of income, referring to countries in which increases in real income levels to date remain dependent upon continuing processes of structural transformation, securing workers’ movement from low to highproductivity sectors, increasing sectoral productivity by competitive and technological means, as well as augmenting human capital infrastructure (McMillan & Rodrik, 2011). Contrary to finding a line of division at a single income level, in the case of countries that are labeled as developing, gaps fall into several categories; human development gaps, capacity gaps, infrastructure gaps, as well as financial intermediary gaps. These appear in varying degrees for resource-rich emerging countries that are middle-class exporting nations, small island nations, and landlocked agricultural nations; but what binds these groups together is vulnerability to risky external finance and terms of trade which ensure convergence is non-linear (UNDP, 2023). Structural transformation is a core aim: this involves reallocating labor and physical capital away from low-productivity subsistence economic activities and toward more productive manufacturing and service activities, increasing average firm size, managerial talent, and intra-firm ties. Successful experiences weave together agricultural growth with export 44   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY constraint, learning by doing in tradables, and indirect networks that capture spillovers; without these ingredients, growth bursts are typically exhausted by nontradables, and real exchange ratios appreciate even as growth continues due to productivity ceilings (Todaro & Smith, 2020). These paths are mediated by institutional arrangements because only credible property rights, non-discriminative enforcement, and capable administration can decrease transaction costs and increase planning horizons for households and firms; without enforcement, investment will be segregated in short-cycle trading and real estate, and informality will be sustained, with rent allocation replacing entrepreneurship. Thus, over time, these political economy effects can produce low-level equilibria even for seemingly favorable exogenous environments, thereby supporting Acemoglu and Robinson’s claim about institutional reform not being supplementary but constituent of development (Acemoglu & Robinson, 2012). Macro-fiscal vulnerabilities overlay structural challenges. Narrow tax bases and shallow financial structures increase fiscal vulnerabilities at a time when fiscal support is required to stabilize economic activity, and governments tend to rely on reduced public investment outlays and Social spending during such episodes. Pro-cyclical adjustments will then ensue with a tightening of global circumstances because debt sustainability can deteriorate rapidly due to interest-rate differential effects or exchange-rate effects on domestic prices (IMF, 2022). Trade and industry policies must strike a balance between openness and capabilities development. Export-orientated policies could reinforce learning by firms and industry organization by complementing solution-orientated approaches to industry policy, which would deal with challenges of coordination, supplier development, and performance-conditioned aid with credible sunset clauses. Sectors closed to all countries or commodities, having large export quantities, may result in shallow integration and stagnant productivity levels even for large export expansion rates (Rodrik, 2007). Human development is at once an ethical imperative and an element in production, as the standard of education and healthcare is what makes possible the use of technology, upgrading, and inclusive growth. Addition without improvement does nothing for skill gaps. On the other hand, mastery in lower grades, improved teaching performance, and reforms in accountability have compounding effects over a lifetime in terms of salaries, technology diffusion, and civic engagement, particularly in environments with low cognitive abilities (Hanushek & Woessmann, 2012). DEVELOPING COUNTRIES   45 The pace and nature of urbanization, together with informality, have created labor market and public finance environments that are both enablers and inhibitors. The advantages of agglomeration are offset by congestion, security of tenure, and service provisions in urban areas, but informality contributes to small tax bases and issues of risk pooling and contributory insurance for a significant segment of the working population. Strategies for easing formalization, with proportional enforcement, can enhance formalization without dampening microenterprise performance (ILO, 2023). Finally, vulnerability to climate change and digital transformation represent this next wave. Typically, vulnerability to climate change can exert pressure on many low and middle income nations with regards to high exposure to heat, floods, and drought. On the other hand, climate-resilient infrastructure and financial arrangements can play a critical role in growth strategies. Similarly, digital platforms and connectivity can help reduce transaction costs, however benefits largely depend on skills, payment and identity systems, competition in data-intensive sectors, and avoiding exclusion (World Bank, 2016). Fiscal Policy in Developing Countries Developing countries are beset by fiscal policy challenges involving simultaneously: managing demand to promote economic stability, securing funds for the process of economic transformation, and establishing the legitimacy of public authority. At the same time, governments are confronted with conditions such as a small tax base and small financial markets, commodity price volatility, and significant needs in human and infrastructure capital. These circumstances leave fiscal space limited, which means that macroeconomic management is rendered exceptionally vulnerable to shock (Gupta, Clements, Baldacci, & Mulas-Granados, 2005). Revenue mobilization in relation to tax is where things go wrong. Large populations of taxpayers who do little, small amounts of third-party reporting, capacity of administration, and an unravelling social contract that impacts voluntary compliance. Sustain strong revenues, tax administration, political will; enhance third-party regimes for microenterprises. For taxation to provide a location for state-building (Brautigam, Fjeldstad, & Moore, 2008). Regarding expenditures, both quality and quantity issues lie at stake. A progrowth character of public investments is possible only in cases, where either the assessment of investments, as well as their development, is strong, whereas 46   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY in other cases, even for equal sums spent on infrastructure, much different results in terms of productivity may be achieved depending on efficiency of infrastructure investments (Dabla-Norris et al., 2012). Developing countries appear to always follow procyclical fiscal policies in terms of rapidly increasing expenditures during good phases, as well as being forced to cut expenditures during bad phases, owing to instabilities in international finances. Following this ideology, the effects of discretionary policies appear to be significantly state-dependent, owing to low multipliers in cases of flexibility in exchange rates, as well as shallow financial systems, as opposed to cases of significant slack and ineffective monetary policies (Ilzetzki et al., 2013). Institutional frameworks can affect both cyclicality and credibility. Medium-term fiscal policies, countercyclical escape clauses, and fiscal councils can mitigate procyclicality if these instruments provide for sustainable investment and social spending through economic downturns combined with commitments to fiscal adjustment over the cycle. Improved rule design and transparency have generally dampened fiscal fluctuations in comparison with commodity price and capital flow volatility (Frankel et al., 2013). Moving ahead, such growth-oriented fiscal policy should incorporate climate change adaptation and mitigation. Climate resilient infrastructure, water, and disaster risk financing can mitigate development reversal and ensure that regions vulnerable to climate change do not fall into a poverty trap, and this green fiscal policy can attract more funds by crowding in investment and minimize fiscal risk exposure (Hallegatte et al., 2016). Finally, capacity to execute is a binding constraint in many environments, and digitization is a force multiplier. E-invoicing, real-time checks, and e-withholding increase audit trails and deter avoidance. Randomized evidence that VAT chaining is effective in improving compliance by designing information in a particular way shows how information design can increase revenues without sweeping reform (Pomeranz, 2015). Government Expenditure in Developing Countries Government expenditure in developing countries needs to finance essential service delivery, bring transformation, as well as stabilize macroeconomic environments concurrently. It is undertaken in an environment characterized by small tax bases, shallow financial systems, as well as high potential exposure for expenditure delivery. The parameter of this policy, rather than focusing on amount, is implementing expenditure in locations of maximum social value by sustainably securing financial integrity. Under this case, quality of expenditure DEVELOPING COUNTRIES   47 is recognized as an important macro determinant, as opposed to a classification marker in itself (Gupta et al., 2005). The allocation decision determines how much of the fiscal space is allocated to investment and consumption, which affects long-term paths because public sector employment, subsidies, and transfers can crowd out investment, but investment with high returns can increase overall output capacity and future revenues. One important finding in traditional allocation theory is that growth is more sensitive to allocation than to actual allocation levels. Unallocated current spending can hinder productivity growth even with unchanged spending levels, but a careful allocation towards infrastructure and quality spending on human capital contributes towards longterm convergence (Devarajan, Swaroop, & Zou, 1996). Infrastructure expenditure such as transport links, adequate power, and communications networks, alleviates bottlenecks that decrease market integration, facilitate trade and search, and attract investment by increasing the expected profitability of complementarities. These effects are both of the aggregative and distributive types. Improved connectivity can bring marginalized areas into the mainstream and allow firms to increase in size, while households derive benefits through reduced logistics costs and improved power supply. These require credible pipelines, competitive procurement, and maintenance prioritization (Calderón & Servén, 2010). In human capital, spending on health and education generates medium-term productivity benefits through improved basic skills, lower morbidity rates, and extended healthy life-years. Marginal returns are sensitivity-driven by quality instead of quantity. Those with a focus on mastering early grades, superior instructors, accountability, and preventive medicine accelerate marginal returns via boosted earnings, quicker technology adoption, and civic engagement. An increase in enrolment without corresponding improved skills or access to primary healthcare means that societal spending has small fiscal multipliers, even with hefty spending allocations (Hanushek & Woessmann, 2012). Under a common physical-social constraint, different architectural possibilities may produce vastly different levels of performance. Therefore, it is important to determine in which area the effective constraint lies; this enhances gatekeeping capabilities, aligns costs with benefits, links costs to milestones, as well as follows up on ex-post evaluations, which in turn is an effective mechanism to raise the marginal product contribution of every dollar spent (Rajaram et al., 2014). Outflows, as well as failings in the provision of services, may also impede effectiveness, with money drifting in the course of time because of a 48   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY lack of monitoring. There have been discrepancies in money allocation versus actual money going to schools or healthcare facilities, as indicated by tracking of public expenditure. Website transparency, citizenship surveillance, as well as changes in healthcare provider incentives, may bring about large welfare gains at a low cost (Reinikka & Svensson, 2004). With regards to spending on social protection, there has been a shift towards targeted safety nets, with a spending emphasis on cash transfer programs, school nutrition programs, and public works. Because these programs have a stabilizing effect on consumption, protect human capital during shock episodes, and have the capacity to expand rapidly if identification infrastructure and transfer mechanisms are in place (Grosh et al., 2008). Climate change vulnerability increases spending on resilience, because flood protection infrastructure, drought-resilient water infrastructure, climate-resilient agricultural practices, and resilient social protection are necessary because unchecked shock exposure can undo several years of progress by destroying public capital and causing households to revert to poverty. Risk-layers and support can combine resilient infrastructure spending effectively to safeguard development progress while reducing long-term fiscal risks; importantly, these would transfer segments of the capital and social budgets from add-ons to safety nets against tail events (Hallegatte et al., 2016). Finally, the financing and governance environment shapes all other elements. Dependence on aid, earmarking, and fragmentation of donors might undermine prioritization with a risk of off-budget silos undermining national planning, while harmonized public financial management and medium-term spending frameworks can improve donors’ disbursements in line with country programs and enhance spending efficiency. Without adequate domestic resource mobilization, enhancing predictability and on-budget-ness is regarded as significant for outcomes, alongside the amount (Mavrotas, 2009). Subsidies and Other Government Transfers in Developing Countries In developing countries, subsidies and transfer programs have multiple purposes. They work to mitigate vulnerable households’ exposure to price fluctuations and income uncertainty. They aim to correct market failures in food subsidies, energy subsidies, education subsidies, and subsidies for healthcare. They also contribute to maintaining cohesion in regions characterized by low state insurance investments in capital markets. The measures encounter strong challenges of fiscal constraints, changing support, and capacity limits. The resulting trilemma is more than a technical issue. They face it between providing DEVELOPING COUNTRIES   49 wide coverage for these programs, adequate levels for these programs, and macroeconomic stability (IMF, 2021). Generalized subsidies, particularly for fuel, electricity, and necessities, are politically sustainable because they are salient subsidies that can be directly observed by consumers. However, subsidies in terms of benefits are regressive because richer households consume more fuels and more durables. Also, subsidies can be expensive in terms of fiscal costs, can have adverse effects on efficiency, and can crowd out spending on activities with higher returns on investment (Coady et al., 2015). Economies that tried unconditional abolition without any transfer programs have experienced significant inflationary effects. There has been a shift towards more targeted cash transfers as the principal means for redistribution. Cases in point confirm that small, predictable amounts for education or for preventive healthcare can improve attendance and use, and decrease inter-generational probabilities of poverty. Such transfers tend to cost more effectively in reducing poverty compared to comprehensive subsidies for prices and can increase capacity to cope with shock situations (Fiszbein & Schady, 2009). Delivery channels matter for effectiveness. Digitized social registries, national identity, and digital payment channels minimize leakages, enhance speed of disbursement, and improve access for hard-to-reach communities. Mobile money channels can even reduce costs of transactions and improve reception timelines, which is important for consumption-smoothing in liquidityconstrained households (Aker et al., 2016). Digital channels are complements for robust grievance redressal, inclusive enrolment, and periodic certification to ensure accuracy. Transfers can also play a role in macro stabilization for countries with only limited formal automatic stabilizers. In recession, disaster, or other crises, social protection programs such as safety nets, public works, emergency cash transfers, and school feeding programs could quickly be expanded in scale. The COVID-19 experience showed that even those with weak state capacity could render more frequent coverage, assuming registries, as well as cash, existed in advance, as social protection infrastructure (Gentilini, Almenfi, & Orton, 2020). Subsidies related to producers, such as fertilizers, irrigation electricity, and credit guarantees, may bring benefits in improving farm output, maintaining stability in farm input prices, as well as maintaining farm household income, but may result in misallocation, opportunistic behaviour, as well as negative externalities, if they are not designed in a manner that links them to performance criteria and sunset clauses. Lessons from reforms in energy subsidies include the 50   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY importance of using savings to support targeted transfer programs in a manner that maintains political acceptability while ensuring macroeconomic credibility (Clements et al., 2013). Looking forward, there will be shock-responsiveness and climate-smart transfers: social protection programs with automatic scaling related to rainfall, heat, and disaster levels; opening up payment windows when local prices are high, and emergency funding that pre-funds fast response. Unifying disasterresilient safety nets with disaster-resilient infrastructure will minimize poverty traps following a disaster and will maintain contingent burdens under control (Hallegatte et al., 2016). Income Taxation in Developing Countries An adequate income tax system in developing countries is required to generate sustainable revenues, promote equity, and enhance macroeconomic stability. However, it is constrained by several inherent impediments such that it faces a considerable degree of informality, limited third-party information, thin administrative structures, and instability in international environments. Thus, it is not only necessary to determine taxation levels but is required to develop supplementary capacities on which it is dependent for converting intentions into actual outcomes. Coming up with these capacities is closely related to fiscal developments (Besley & Persson, 2013). Due to formal employment opportunities that are limited and where small businesses predominate, the personal income tax can have a small tax base that is anchored on public and big private sector employers, whereas high-net worth self-employment and closely held businesses tend to be on the borderlines between avoidance and evasion. Thus, it can be noted that a thin segment of employment is dependent on source withholding in several nations, which contributes to top non-wage income sources largely going undertaxed—which is one reason for a relatively low-tax-revenue performance compared to developed nations for the PIT (Bird & Zolt, 2005). Governments rely heavily on corporate income tax and a combination of tax holidays and investment tax allowances. However, costly provisions in these systems include preferential treatment, accelerated depreciation, and special treatment, which leads to base erosion and administration problems. Observations in investment tax allowance programs clearly demonstrate that cost-effectiveness is low and there is redundancy, providing justification for moving towards transparent tax allowances with sunset provisions and robust DEVELOPING COUNTRIES   57 examination of former and existing taxation systems that assess the framework of financing through revenues and the treatment of personal income tax, considering other forms of tax such as consumption taxes and value added taxes. It also explores the costs involved during the adoption of progressive income taxation systems within the developing world. The paper makes use of experiences and findings of financial institutions to evaluate the potency of various tools of taxation concerning issues such as equity, efficiency, and mobilization of revenues. The findings indicate that the effect of personal income taxes on inequality has been negligible in developing countries because of the challenge of small tax bases and poor enforcement, as well as the existence of unreported economic activities. The study also shows that the largest revenues are derived from taxes that are related to consumption in developing countries. These taxes are considered to be regressive and require formulation to address issues of inequality. Apart from that, the article also shows that the effect of inequality could also be achieved through expenditure related to the development of education services, health, and infrastructural development rather than through income taxes. The originality of the study resides in the fact that it critically examines the hypotheses put forward concerning the redistributive role of personal income taxes within the framework of developing economics. It redirects the spotlight toward expenditure policies and other forms of taxation that call into question the currently pursued fiscal policies. The study resorts to history for the formulation of fiscal policies that emphasize the aspects of efficiency and political feasibility of the taxation policies. Carnahan (2015) explores the difficulties faced by developing nations with the task of establishing appropriate taxation systems to ensure the development of the economy. The study clearly indicates that the task of taxation plays a crucial role within the state and the process of development. As such, the management of taxation must ensure that the mobilization of funds is related to the provision of important services with the objective of enhancing the relationship between the state and the people. The study has managed to explain the difficulties that might be linked to low capacity and the political realities that might lead to the rapid globalization that interferes with the activities of the economy and thus the development of adequate taxation systems. The methodology used relies on the data gleaned through the public expenditure and financial accountability evaluation scores that have been undertaken across a wide range of developing nations. The methodology relies essentially upon the scrutiny of the various revenue cycles within the scope of criteria that pertain to 58   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY the level of transparency, taxpayer registration, and the level of efficiency that is used within the resultant collection of revenues. Thus allowing for a comparison within the broader scope of best practices concerning the administration of revenues. The methodology also relies upon a level of data that is linked through a level of theoretical perspective that concerns financial practices and governance, thus ensuring a level of in-depth scrutiny concerning the level of challenges that exist within the administration of revenues through the economy of the developing nations. The findings show that although there exist countries that are doing relatively well when it comes to mobilizing revenues to achieve the targets, there are challenges related to the issue of registration, transparency, and enforcement of the matter concerning taxpayers. The study explains the challenges related to the management of the various bases that are composed of revenues generated through income, consumption, and natural resources. It also outlines the challenges related to the issue of globalization activities that involve managing issues such as the erosion of the taxing base related to the migration of profits to other nations and the issue of tax evasion that affects the revenues of governments. The originality of the study arises from its comprehensive and interdisciplinary perspective on the analysis of taxation within the context of developing economies. The combination of the technical analysis of taxation with the political and economic environment provides this article with insight that goes beyond the application of traditional taxation models within the context of the developing world. The perspectives presented in this article are original due to the emphasis placed on the need to develop capacities within these economies to respond to international pressures within the context of taxation regimes that are adapted to these economies. Auriol & Warlters (2005) investigate the reason behind the smaller direct taxation base among developing countries compared to developed countries. They believe that the extent of the informal sector and the entry barriers to the formal sector are key drivers that impact the collection of taxes and the generation of revenues. The study contests the widely accepted proposition that the existence of the informal sector is an unavoidable reality that affects the collection of taxes. Instead, the study puts forth that governments can use such entry barriers to ensure efficient collection of taxes with minimal costs. In other words, governments can use the creation of oligopolies in the formal sector to extract rents from large taxpayers. The methodology consists of theoretical models and empirical studies performed over a large sample of various countries. The study uses a theoretical model that explains the behaviour DEVELOPING COUNTRIES   59 of industrial organizations following the tenets of the principles of constant return to scale. The governments are required to set the optimum entry fee and profit tax such that the maximization of revenues is achieved. The theoretical model used in the research employs empirical tests using regression analysis for over sixty countries. The empirical analysis applies various factors such as the measures of the shadow economy, gross national product per capita, population, and entry fees measured as the percentage of per capita income. The empirical analysis utilizes ordinary least squares and two-stage least squares to account for endogeneity that might exist due to the relationship between entry costs and the shadow economy measures. The findings indicate that the magnitude of the informal economy is positively related to market entry barriers and negatively related to national income and population. Furthermore, the results show that the magnitude of the informal sector tends to lower the total tax base. However, higher entry barriers can raise the total taxes payable by focusing taxation on the few firms operating in the formal sector. This policy package has implications for efficiency because it hinders the development of small-scale enterprises and triggers a rise in prices because of the reduced level of competition. The study shows that the taxation policy package might hinder growth because the policy focuses on minimizing structural distortions in the market. The originality of the study is that it focuses on the intentional role of public policies, not considering these sectors as autonomous factors that require consideration. The connection between the barrier to entry into the market and the level of tax revenues, and the size of the informal sector, provides a unique perspective that does not align with the models that are related to taxation and are linked to developing countries. This study also provides a workable model that is capable of being scaled up through the expansion of the existing tax base through the reduction of barrier to entry through other forms of taxes such as the value-added tax. 61 CHAPTER IV LEAST DEVELOPED COUNTRIES Least Developed Countries Least Developed Countries are more than countries with low income in a one-dimensional income classification, given their definition in regard to having structural handicaps, in such a way that their low per-capita income, together with their low human resources, constitute vulnerability to environmental hazards among other facets. It’s centred on their inherent weakness in their productive capacity, such as less diversified exports, low productivity in agriculture, less diversified industries, and institutions, which basically guarantee those countries to have short-lived growth patterns, significantly vulnerable to external elements such as prices of commodities, natural hazards, among other elements. It aimed to point out those natural constraints by incorporating different indicators on income, human resources, and vulnerability, in such a way that it emphasized identifying not solely a resource issue, but rather an issue in having growth stumbling blocks in their systems (UNCTAD, 2021). Another major issue for Least Developed Countries is structural transformation, which entails economies with high dependence on subsistence sectors and countries with primary commodities seeking to transform into a more productive manufacturing and services sector. Domestic markets in most countries in these regions are small, with high transport costs, no efficient electricity, and financial sector restrictions, which could hamper any effort to grow businesses to optimal size in pursuit of enhanced productivity levels and integration into value chains in their respective regions. But, after undergoing booming growth realized through primary commodities and foreign assistance, their policies tend to overlook job-creation efforts in these countries, which could be reversed during low growth periods. This aligns with the interpretation that some countries in these regions are locked into development traps like conflict, natural resources, and land-lockedness, which could significantly influence these countries to transform their economy’s structure from low productivity subsistence to an advanced sector (Collier, 2007). 62   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY The political institutional setting is an important factor in whether these countries have any chances of being locked into such patterns or whether they manage to figure out ways to escape from such patterns. If there’s a political institution in which power is personified, there aren’t any restrictions on such power, then there could be inefficient allocation in such countries, given their resource availability, due to patronage, which could result in an unreliable policy environment. On the other hand, if there’s simply an improvement regarding rule of law and impartiality, it could be immensely beneficial for countries in general in the context of Least Developed Countries. It could happen due to low transaction costs, simplicity in reaching agreements, and increasing governments’ reliability regarding their policies (Acemoglu & Robinson, 2012). Macro-financial management in LDCs is further complicated by having tax bases, which are comparatively small, to a large extent, externally funded. Their budget cyclically dependency on trade patterns and aid support stands significantly vulnerable to trade cycles and aid support patterns. Their domestic support comes from trade taxes, simple consumption taxes on their small formal sector, and extraction on some few commodities being exported, which significantly makes their fiscal performance sensitive capital aid support and associated opportunities. Furthermore, their budget expenditures have significantly large components, such as grants, soft loans, which to a large extent, are disaggregated on aid support and allocated to some specified sectors, significantly hampering medium-term budget planning on these lines. Empirically examining growth outcomes in studies on growth patterns influenced by various patterns on composition, specifically on timing, in patterns on composition, postulate aids with short-term targeting, for example, on infrastructure support, budget support, to have some significantly beneficial contribution to economic growth patterns, on condition these ideally fit into broader strategic planning patterns, while variability in such patterns offsets these beneficial outcomes in economically challenged settings (Clemens et al., 2012). Capabilities in LDCs are deficient and interact with LDC status to enter into feedback mechanisms to affect capabilities over multiple generations. This is because many LDC countries have increased educational enrolments but still experience serious gaps in knowledge acquisition, where a considerable proportion of children attain primary school but fail to acquire simple literacy and numeracy skills. On the other hand, many experience problems concerning funding, human resources, and availability of value chains to cater to vital medicines within their respective health care systems. This manifests low child and LEAST DEVELOPED COUNTRIES   63 maternal survival, high prevalence of stunted children because of undernutrition, and poor access to reproductive assistance, which hampers productivity within labour as well as inhibits present and future capital accumulation to enhance the capabilities of children, forming a vicious cycle whereby low capabilities entail low economic transformation, while low economic transformation implies constrained capacities to enhance capabilities (Sachs, 2005). The LDCs are also more vulnerable to the impacts of climate change and natural disasters. Additionally, the ability to deal with the risks of natural disasters is lower in the LDCs. Drought, floods, tropical cyclones, or heatwaves may therefore lead to the destruction of agricultural produce, infrastructure, and the cost of rebuilding. This may bring countries into the poverty trap where the only choice is to discard economic assets and not rebound before the next natural calamity. Climate-poverty research shows that if more attention is not paid to making infrastructure and agricultural programs climate-resilient and social protection programs more adaptable to these conditions, there is a strong probability that climate change will undermine any developments within LDCs and increase differences between those countries and more developed countries (Hallegatte et al., 2016). Fiscal Policy in Least Developed Countries In Least Developed Countries, fiscal policy has tripartite role: supporting essential state activities and corresponding public goods, promoting structural change, and at least ensuring what is obviously a minimalist social protection agenda within extremely limited income, finance sector depth, and transitivity to external and weather-related shock transmission. There is very little room to play the standard textbook role of counter-cyclical policy, while ministries of finance function in fire-fighting mode, simultaneously dealing with arrears, donor disbursement constraints, and commodity prices rather than dealing with any output gap. The theoretical challenge is to devise how to select a particular optimal policy setting rather than to construct a rudimentary fiscal state, that is, tax administration, budgeting, management of public debt. Such that over time, one can actually increase this policy choice boundary to expand the role of finance within this setting rather than presupposing them exogenously (Besley & Persson, 2013). Turning to the revenue side, domestic resource mobilization is systematically limited by a subsistence economy, limited use of banking and electronic payments, and high tax administration costs due to small geographically dispersed taxpayers. This necessarily leads to LDCs’ dependencies on a limited 64   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY toolkit, such as trade taxes, simple consumption taxes on a limited formal economy, and profit taxes on a couple of giant enterprises, commonly in natural resource industries. This necessarily implies that tax receipts are extremely cyclically sensitive to international trade prices and quantities, while horizontal equity suffers due to exemptions negotiated by better-connected businesses and rich citizens. The state-building literature recommends beginning taxation on simple tax bases such as customs, excises, and formal wage taxes with thirdparty information and registration, rather than beginning on graduated income taxes having higher cognitive complexity that surpass administrative capacities (Bird & Zolt, 2005). On the expenditure side, fiscal policy in LDCs faces the challenge of balancing immediate expenditures, such as paying salaries to school teachers, nurses, and civil servants, operating and maintenance costs, and subsidies to make access to essential services affordable, with the imperative to increase capital expenditures that are productivity-boosting and increase future tax receipts. What matters most to aggregate economic growth is not aggregate expenditure but rather its pattern, current consumption versus expenditures on productivity-boosting capital formation, but political economy factors and aiddriven allocations often shift expenditures toward more immediate, visible gains rather than toward public expenditures on capital formation in infrastructure and human capital. A budget allocation preference that favours immediate expenditures can lock countries into a low-growth track when inadequate capital expenditures result in a small tax base that, in turn, locks both capital expenditures and foreign aid into perpetuity (Gupta et al., 2005). The experience of macroeconomic stabilization is particularly difficult due to the propensity of fiscal policy to operate pro-cyclically, with increased expenditures during periods of strong economic growth and simultaneous sharp cuts during periods of recession. The limited availability of long-term finance within LDCs and inadequate capital markets also make it impossible for such countries to resort to borrowing in their own currency to stabilize their economies, while access to external markets is expensive and episodic. This results in external developments such as commodity price collapses, sudden stops, natural disasters being immediately converted into budgetary crises, arrears, and reduced expenditures on social programs. The experience across countries indicates that such procyclic behaviour is more evident when institutional factors make it difficult to rely on fiscal policy stabilization mechanisms in LDCs, regardless of their urgency (Frankel, Végh, & Vuletin, 2013). LEAST DEVELOPED COUNTRIES   65 One of the special characteristics of fiscal policy in LDCs is the presence of aid and other forms of concessionary financing that can represent a very large share of a developing country’s overall public investment expenditures and total recurrent expenditures. At first glance, grants and very concessionary loans can significantly enhance a country’s fiscal space to finance its priorities such as infrastructure, social services, and stabilization programs without necessarily raising distortionary taxes and taking on unsustainably expensive commercial debts. Yet, aid volatility, diversity, and propensity to earmark can compromise medium-term budget planning and domestic budgetary accountability if not absorbed within a single budget structure. Studies dis-aggregating aid flows into more specific sources and timing effects identify that short-impact aid such as infrastructure and budget support programs can have positive impact on growth when aligned to strategic country programs, but also point out how aid flows that are less strategic about timing can make medium-term budget planning more difficult and increase macroeconomic uncertainty within very fragile LDC environments (Clemens et al., 2012). Finally, vulnerability to climate change and other shock events imposes a specific type of fiscal agenda on LDCs due to high demands to cover expenses triggered by disasters but limited buffers and insurance arrangements. Drought, floods, or natural disasters could devastate both public and private capital, reduce tax revenues, and require governments to draw on limited resources to shift priority expenditures to such disasters, thereby crowding out capital expenditures to sustain growth and deteriorate debt sustainability. As lessons learned from work on climate change and poverty impacts, failure to take these actions could increase significantly the numbers seeking assistance to return to poverty and generate a poverty traps scenario with implications on sustainability of LDC public finances and development outcomes (Hallegatte et al., 2016). Government Expenditure in Least Developed Countries Government expenditure in Least Developed Countries is to support a very heavy burden because it is supposed to cover the expenditures required to sustain governmental functions, increase access to essential services, and cover expenditures required to execute transformations while operating within extremely low incomes, high unpredictability, and low institutional capacity. The budget structure is characterized by very limited taxation streams and aid inflows, making these countries sensitive to terms of trade disturbances, aid flows, and natural disasters influencing budget outcomes. This makes it rather difficult 66   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY to execute long-term programs and secure essential social expenditures during deteriorations. The UN system’s observation on LDC analyses continuously confirms that due to low budget capacities and constraints, rather than having to fine-tune expenditure policy, there is more emphasis on making hard trade-offs between sustaining state operations and developing capacities required to ensure growth in the future (UNCTAD, 2021). The expenditures of many LDCs are dominated by salaries, generalized subsidies, and other recurrent items, while expenditures on infrastructure and other growth-promoting services continue to receive low priority. This is due to political economy reasons such as the political gains achieved by wage increments and fuel or food subsidies, and earmarks by aid donors that tend to disperse expenditures into numerous small projects. Studies on low-income countries indicates that without any growthrelated expenditures, but rather due to compositional change toward capital accumulation and high returns on social expenditures, there is acceleration of growth outcomes, while those dominated by consumption continue to result in low productivity equilibrium trajectories where tax base remains inadequate to alleviate constraints within low-income countries (Gupta et al., 2005). The quality of public investment is another central issue. LDCs have huge gaps in infrastructure, but inefficient project evaluation and implementation mechanisms result in a considerable share of budget expenditures being converted into non-growth assets. The issue is compounded by leakage, delays, and early degradation of assets, particularly when such expenditures are policydriven rather than reached on the basis of economy-wide costs and benefits. Studies on management of public investments suggests that improving both up-front gate-keeping and down-stream implementation can significantly increase the growth return on a given level of expenditures, which can have serious implications if budget space is very limited (Rajaram et al., 2014). The social services’ expenditures tend to involve low per-capita outlays and high recourse to external financing, while constraints on service delivery diminish marginal returns to every dollar allocated to such expenditures. The allocation of resources to basic educational provision is often consumed by salaries within educational bureaucracies that continue to generate low outcomes, while a typical health budget has to stretch to meet demands related to primary care, maternal and child services, and dealing with repeated outbreaks. Studies on development points to productivity outcomes being functions of expenditures’ quality rather than mere quantity, which raises both input and deep-seated institutional issues that LDCs have to address to improve productivity, such LEAST DEVELOPED COUNTRIES   73 government expenditure makes a positive addition to growth and reinforce the contention that government investment matters significantly in the development of economies that do not have adequate capacity on the part of the rest of the economy. Additionally, the study finds that there are neither direct nor indirect effects of efficiency on the relationship between government expenditures and growth. Trade openness and employment growth are other variables that make a positive addition. The results illustrate that although government expenditure makes a direct addition, efficiency issues hamper the extent of its effects on growth. This result reinforces the contention that an increase only in government expenditure matters but not an increase of its quality. The originality of the article consists of the fact that it combines the scale of government expenditure with the efficiency of its distribution, an approach that has received very little attention in other scientific investigations focusing on Sub-Saharan countries. Significance of this study emanates from the incorporation of the institutional factor, which introduces an extra dimension on why expenditures by governments do not result in automatic outcomes regarding growth performance. Another element with significance in regard to this study is its applicability in relation to consequences associated with fiscal policy formulation. Lim (1983) analyses the relationship between recurrent expenditures by governments and overall economic growth in less developed countries. It contests the common view about recurrent expenditures being less essential to economic development, given its character being viewed as an expenditure for consumption, unlike capital expenditure. It also discusses some negative consequences for ignoring its importance or allocating inadequate funds to these repeated expenditures, such as underperforming infrastructure projects because of inadequate operational expenditures. It seeks to examine, through its analysis on repeated expenditures, if less developed countries have placed more emphasis on capital expenditures relative to overall efficient growth. The methodology involves analysing data from fifty-four less developed countries for a specific period, taking into consideration overall, as well as sector-based, expenditures by governments. Ordinary least squares regression analysis methods are used to investigate whether there are tendencies towards decreases in regular expenditures in different sectors such as agriculture, education, health, and transport. It also investigates stability in expenditures on capital compared to those on recurrent expenditures in regard to variability. It is observed from the results that there is no concrete evidence regarding the reduction in recurrent expenditures in these countries. Although some areas, such as 74   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY health, have observed indications to reduce expenditures on recurrent costs, there is no concrete evidence to support the fact that there is deprioritization regarding recurrent expenditures. It has also been observed in some areas such as education, health, agriculture, and transport that there is no stability in recurrent expenditures in comparison to capital expenditures, indicating some weakness in ensuring these projects are at their optimal levels. But, there is some stability regarding recurrent expenditures in agriculture, transport, and other areas in comparison to capital expenditures. The originality of this study lies in emphasizing the aspect of repeated expenditures, which is a crucial yet neglected element in development in relation to capital expenditures. It is with this emphasis on recognizing not only trends in expenditures, including capital for developmental objectives, but also their stability, that this article comes out with a crucial developmental paradigm influenced by fiscal elements. It not only emphasizes capital expenditures for developmental objectives in improving infrastructure, but also operational expenditures, which are crucial in less developed countries in optimizing expenditures for developmental objectives. Hermes & Lensink (2001) examine the interaction between fiscal policy in less-developed countries, specifically its relationship to private investment, while taking into consideration its nonlinear relationship. It is indicated in the study that fiscal policy, being an instrument for improving economic performance, could have different roles, some at times conflicting, in private sector investments. By examining different expenditures and income components, there could be a more accurate way to distinguish the effect of fiscal policy on private investments, compared to the practice of simply examining overall fiscal policy variables. It also investigates ways in which structural adjustment policies could be defined in support of private sector performance. The methodology entails panel data, which is based on observation from a cross-section of less developed countries over three decades. Generalized least squares techniques are utilized to deal with problems of heteroscedasticity, while including both linear and quadratic components to establish whether there are any nonlinear relationships. It distinguishes among different types of government expenditure, such as capital, salaries, subsidies, and interest, whereas different types of income, such as income tax, domestic tax, and other trade taxes, have also been included. By incorporating fixed effects, differences among countries, as well as differences over time, have been controlled for. The results indicate that there are divergent effects of fiscal policy on private investment based on its components. Public expenditure on capital has a crowd-in effect on private investment, whereas LEAST DEVELOPED COUNTRIES   75 increased wage bills and other types of current expenditures have crowdout effects based on inefficiency and imbalance in fiscal policy. Non-linear relationships are observed, with capital expenditure having positive effects after exceeding a particular level, whereas other types of expenditures and taxes face diminishing returns after overcoming particular levels. It is also indicated that tax policy is complex based on its effects, whereby some taxes have positive effects on private investment at low levels, yet they affect private investment negatively once they are excessive. The originality of this study is in its disaggregated method for examining fiscal policy. By incorporating techniques from non-linear models, it provides new information on private investments, which have not been highlighted in any existing studies on developing countries. It not only improves upon the prevailing debate on the interaction between crowding-in/crowing-out effects in fiscal policies, thereby encouraging theory, but also guides the formulation of policies. It suggests fiscal policy reform to deal with necessary expenditures, in addition to its treatment in taxes, to create opportunities for growth in the private sector. Gupta et al. (2005) investigate fiscal policy, together with compositional expenditures, in low-income countries, to analyse their impact on growth. The publication’s interest is in identifying whether adjustments in fiscal policy, aided by compositional changes in governments’ expenditures, affect growth in economies with resource constraints in their environments. It aims to verify whether adjustments in fiscal policy, with enhanced compositional changes in governments’ expenditures in areas such as investment, have some beneficial outcomes on growth in economies with resource constraints in their budgets. The methodology uses panel data analysis on a sample of low-income countries in the 1990s. It combines different econometric models such as fixed effects estimation and Generalized Method of Moments to correct for endogeneity and individual heterogeneity. Various model specifications are employed to capture fiscal stance, financial composition, and different types of expenditures, with particular attention to differences between current and capital expenditures. Other variables such as private investment, labor growth, indicators for human capital, and exogenous variables are employed to capture other issues affecting economic growth. The findings appear that fiscal adjustments are not harmful to growth if such adjustments are realized in relation to improvements in current spending, rather than reductions in investments in capital expenditures. It is emphasized in the results why capital expenditures are vital in improving growth performance, while overly high spending on labour and other transfer payments 76   THE POLITICAL ECONOMY OF FISCAL POLICY EFFICIENCY have proved to be counterproductive. It has also been demonstrated in these results that financial support for fiscal adjustments affects growth performance to some extent, with domestic support being more growth-retarding, due to its resulting inflationary pressures, rather than foreign support for such adjustments. It has also been determined in these results why growth performance, in relation to fiscal policy, is affected in varying ways, depending on countries’ respective initial conditions, in regard to overall macroeconomic stability considerations. The originality of this study is in its comprehensive method for evaluating fiscal policy, which integrates the analysis of budgetary balance, composition of expenditures, and funding patterns in one model. Its results regarding the differential effects of various elements included in public spending on growth are informative for those seeking to formulate fiscal adjustments conducive to growth. The study clearly explains that in low-income countries, for fiscal policy to be efficient, governments must not only curtail their expenditures, but efficiency in those expenditures must also be enhanced. Haile & Niño‐Zarazúa (2018) analyse whether there is any contribution of government social expenditures, especially in such areas like health, education, and social security, to enhanced overall welfare in low and middle income countries. The study has emphasized that although social expenditures have long been proved to be an essential tool for improving overall human development and poverty alleviation, their relative efficacy has largely remained controversial with inconsistent evidence being produced in different studies. By concentrating on such areas like Human Development Index, and child survival rates, the significance of any potential relationship between overall developmental expenditures made by governments in countries with pronounced developmental gaps in their respective countries could be identified. The methodological approach relies on the concept of utilization of a longitudinal dataset for fiftyfive low and middle income countries for two decades. To alleviate concerns of endogeneity, dynamic panel data analysis has been employed. Various control variables have included economic variables like GDP, openness to trade, institutional strengths, and democratization, which have played an immensely critical role in understanding the macroeconomic environment in which social expenditures function. The findings from the regression analysis denote the presence of a positive relationship between social expenditure by governments and overall welfare indicators. It is observed that social expenditure positively influences overall welfare indicators, such as child mortality rates, thereby emphasizing again that there are concrete dividends in overall welfare in these LEAST DEVELOPED COUNTRIES   77 expenditures. But in addition to governments disbursing funds for social needs, there are moderating forces, such as the character or type of their governance, which generate more efficient outcomes in overall welfare on given levels of such expenditures, thereby not only underlining the importance of quantities, but also their importance in relation to their qualities. The originality in this study is based on its approach in methodology, whereby it incorporates a massive dataset with state-of-the-art econometrics in analysing some perennial questions concerning the efficiency of social expenditures. 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