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Chapter nine: Structural adjustment policies, parallel markets and economic surplus
The discussion in the previous six chapters did not consider government spending or operations, but only the magnitude of the total surplus, that is available to the economy for public spending and public or private investment. This surplus is derived from non-agricultural sector profits and trade taxes. Non-agricultural sector profits do not all have to accrue to the private sector if the government owns some corporations directly involved in productive activities, as is customary in many developing countries.
Consider now the nature of government current spending G. Since the sum of this and total investment l is equal to the magnitude of the economic surplus R as discussed in Chapter 3, the allocation of the surplus between G and I, is a matter of political economy. For instance if all non-agricultural productive activity is publicly owned, then all the surplus accrues to the government who decides about G and I. There is a minimum of government needed if the internal terms of trade are to be different than the international ones. The mechanisms for export and import taxation for instance, such as marketing boards and customs officials, all entail a cost. Ideally, of course this cost should be a small fraction of the revenue collected. Some basic public services such as police, defense, education, and health, as well as some public administration, also entail some real resources. In a well managed developing economy, these costs should not take up a large portion of the surplus so as to leave some for domestic capital formation.
The problem with many of the late developing countries, and certainly with most of those in sub-Saharan Africa has been that the state ended up appropriating an inordinate amount of the economic surplus, for current consumption G. leaving very little for domestic investment. In fact one of the major reasons precipitating the crises in many countries was the deterioration in physical capital and infrastructure, which reduced the capacity of the economy to produce.
Investment in many countries during pre-crisis periods was largely maintained through external donor support. In terms of the model developed earlier, a large part of foreign savings was utilized to maintain domestic investment levels. However, the decline in availability of foreign exchange that usually preceded the crises exposed the severity of the problem of appropriation of the domestic surplus.
There are several mechanisms of public appropriation of the non-tax economic surplus. (Which in the model analyzed above is identified as non-agricultural profits P ). A relatively straightforward one is when all non-agricultural (and some agricultural) capital and firms are owned by the state. This is an extreme situation which prevailed in several centrally planned economies in Eastern Europe, and it is no coincidence that the scissors problem was first analyzed in the context of such economies.
In economies where non-agricultural capital ownership is mixed, a substantial portion of profits accrues to the private sector. However, unless firms are small and/or hold their profits in cash, they will deposit a substantial portion in the banks. If these in turn are state owned, or state controlled, a situation which is most prevalent in developing countries, then appropriation of the surplus can occur through the allocation of credit. For instance financing losing corporations or marketing agencies, through overdrafts is equivalent to appropriating investment funds for current consumption. Direct taxation of profits is also possible but it is not a large source of revenue in developing countries.
Another way of appropriating surplus is through the inflation tax. This refers to the erosion of the purchasing power of domestic money holdings. This can happen through inflation, generated, by expanding the domestic money base in order to finance public deficits. The reduction in real purchasing power of the domestic money holders is the real value of the tax.
The major effort of stabilization programs is to reduce current public spending, which in our framework may reduce investment. Structural adjustment programs, on the other hand, in addition to reducing the role of the public sector try to improve the internal efficiency of the economy and bring the real exchange rate closer to its equilibrium value. The resulting increases in incomes tend to increase domestic resources to the public sector, and thus favour increased public investment. In agriculture the reforms usually take the form of liberalizing domestic marketing of both non-traceable as well as export crops.
It was discussed earlier that export marketing boards can be an efficient mechanism for revenue collection while preserving the economies of scale needed for international marketing. There are many marketing boards in both developed and developing countries, which are owned and operated by producers, and are quite efficient. Taxing agriculture through such institutions is quite easy and does not differ from indirect taxation of any corporation. Given that profits are returned to producers, there is every incentive to keep operations efficient. The problem with many developing country marketing boards is that they were expropriated by the state, and operated with state rather than producer interests in mind. It is no accident that they quickly became very inefficient, and they are rightly targets of reform.
Given the above discussion and the earlier model, structural adjustment programs, by decreasing the internal taxation of agriculture might be considered as decreasing the real value of the total surplus of the economy. On the other hand by trying to reduce the role of government and the magnitude of current public spending G. they try to shift a larger share of the economic surplus towards investment. The net outcome as far as aggregate investment is concerned is ambiguous.
This logic, however, is based on the assumption that the economy and the internal terms of trade can be costlessly manipulated by the state. The earlier discussion assumed that the internal terms of trade could indeed be effectively controlled. The very large rates of taxation of exports, and agricultural products in developing countries, however, have in most cases created parallel markets where goods are exchanged at market rates. In other words control of the internal terms of trade is lost through the parallel market mechanism. Given the possibility of parallel markets, the situation arises whereby stricter controls, namely higher effective rates of taxation, might lead to more evasion through parallel markets. In such situation, it is possible that the effective tax revenue of the state might increase up to a certain point with increasing rates of taxation, but decline thereafter through erosion of the tax base, along well known Laffer curve type of reasoning. In other words part of the economic surplus generated by the economy moves beyond possible appropriation by the state.
This thinking, however, raises another issue relevant in the context of adjustment. Parallel markets, which develop in response to economic controls, shift part of the economy's activity to an uncontrolled unofficial mode. However, economic activity in the parallel sector does generate its own surplus in addition to the surplus of the "official economy". Does the imposition of controls in the presence of parallel markets imply that the total real value of the economy's surplus, is lower than in the case of no parallel markets? It is not a-priori clear what the answer to this question is. The reason is that existence of parallel markets creates rents. To enter parallel markets usually involves real costs in terms of time lost to non-sanctioned activities, but also involves transfers as those offering parallel transactions, must be matched with those demanding the transactions, and the intermediaries make nonproductive profits.
The existence of parallel markets implies in practice that the effective internal terms of trade of agriculture, defined as a weighted average of the controlled and uncontrolled terms of trade, cannot be depressed beyond a certain point. If this point is above the point of maximum surplus analyzed before, then the surplus generated by the taxation is smaller than what is theoretically possible. Equivalently, one might reason that in the presence of parallel markets there is a point of official taxation which will generate the maximum total economic surplus. This level of official taxation might be larger than what is dictated by the case of complete control, because one has to balance the large surplus generated by large taxation of the controlled sector with the small surplus generated in the uncontrolled sector.
In such an initially distorted setting, reducing the official rate of effective taxation will reduce the total surplus generated by the controlled sector, but by lessening parallel activities, will increase the size of this sector. The effect on total surplus could be positive or negative. However, when the reduction of the degree of control and taxation is coupled with a reduction of the size of the state by reducing the real value of G. then the likely impact is an increase in the surplus available for domestic investment. All structural adjustment programs, in addition to prescribing lower official effective taxation of traded goods, usually specify a reduction in the size of government. According to the logic discussed above this has the effect of releasing more domestic resources for investment and hence growth, albeit it might reduce the size of the aggregate economic surplus. In other words, the existence of parallel activities is likely to strengthen the case for structural adjustment programs as far as generation of investment is concerned.
That structural adjustment programs which aim at changing the real exchange rate must be accompanied by fiscal reforms, has been recognized in the theoretical literature both in the absence of parallel markets (Khan and Lizondo (1987)), as well as in the presence of parallel markets (Pinto (1991)). However, in none of these or other works have the implications of reforms on aggregate investment been analyzed. The discussion here suggests that the issue of whether total economic surplus available for domestic investment (namely total surplus minus current public spending), increases or not after reforms depends on the degree of prior suppression of the internal official terms of trade, coupled with the nature and extent of parallel markets created by the controls. Albeit the prior existence of parallel markets should increase aggregate investment from structural adjustment programs, more than in the absence of parallel markets, it is not clear if the total surplus of the economy increases or not. It should be emphasized that the discussion above has focused on a rather narrow issue, i.e. changes in the availability of investment funds as a result of structural adjustment programmes. The magnitude of investment funds does not necessarily determine their growth effects. The latter will be determined by the efficiency of investment, i.e. the sectors and projects on which investment will be allocated as well as the magnitude of distortions in the economy. Thus, lower investment in a relatively undistorted economic environment may be more efficient in promoting growth than higher investment in a distorted economic environment. Moreover, the extent of distortions in the economy may be itself dependent on the way funds are raised which, in turn, reflects to a large extent the mode and magnitude of agricultural taxation.