THE WORLD BANK RESEARCH OBSERVER 176 18 Development, the Environment, and the Social Rate of Discount Anil Markandya and David W. Pearce Reaching the Rural Poor through Public Employment: Arguments, Evidence, and Lessons from South Asia Martin Ravallion Cash Flow or Income? The Choice of Base for Company Taxation Jack M. Mintz and Jestus Seade The Market for Developing Country Debt: The Nature and Importance of Its Shortcomings John Wakeman-Linn The Relative Efficiency of Private and Public Schools in Developing Countries Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo NX Reform of Trade Policy: Recent Evidence S from Theory and Practice Vinod Thomas and John Nash A. THiE WORLD BANK RESEARCH OBSERVER EDITOR Ravi Kanbur COEDITORS Vitrorio Corbo, Shahid Yusuf CONSULTING EDITOR Philippa Shepherd MEIMBERS OF THE EDITORIAL BOARD Angus Deaton (Princeton University, United States), Shantayanan Devarajan (Harvard University, United States), Mark Gersovitz (University of Michigan, United States), Shuja Nawaz (International Monetary Fund), Vittorio Corbo, Dennis N. de Tray, Enzo Grilli, Ravi Kanbur, Peter Muncie, George Psacharopoulos, William Tyler, Shahid Yusuf The World Bank Research Observer is published twice a year, in January and July, by the International Bank for Reconstruction and Development (the World Bank). It is man- aged in the Office of the Senior Vice President, Policy, Research, and External Affairs, and the editorial board is drawn from across the Bank and the international community of economists. 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The World Bank encourages dissemination of its work and will normally give permission promptly and, when the intended reproduction is for noncom- mercial purposes, without asking a fee. Permission is not required to make photocopies for classroom and similar immediate use. The World Bank Research Observer is indexed by the Journal of Economic Literature, the Standard Periodical Directory, the Public Affairs Information Service, Inc., and, online, by the Economic Literature Index and DIALOG. It is available in microform through University Microfilms, Inc., 300 North Zeeb Road, Ann Arbor, Michigan 48106, U.S.A. THE WORLD BANK RESEARCH OB1SERVER VOLUME 6 NUMBER 2 JULY 1991 Development, the Environment, and the Social Rate of Discount Anil Markandya and David W. Pearce 137 Reaching the Rural Poor through Public Employment: Arguments, Evidence, and Vessons from South Asia Martin Ravallion 153 Cash Flow or Income? The Choice of Base for Company Taxation Jack M. Mintz and Jesus Seade 177 The Market for Developing Country Debt: The Nature and Importance of Its Shortcomings John Wakeman-Linn 191 The Relative Efficiency of Private and Public Schools in Developing Countries Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 205 Reform of Trade Policy: Recent Evidence from Theory and Practice Vinod Thomas and John Nash 219 Cumulative Index, 1986-1991 241 DEVELOPMENT, THE ENVIRONMENT, AND THE SOCIAL RATE OF DISCOUNT Anil Markandya David W. Pearce This article examines the role of the discount rate in making decisions that will have significant implications for the environment. The authors begin by pro- viding a rationale for discounting in general and by describing the main factors that determine the discount rate. These factors-the private and social rates of time preference, the opportunity cost of capital, risk and uncertainty, and the interests of future generations-all have an environmental dimension. The ar- ticle goes on to examine that dimension and to explore the connections be- tween the choice of the discount rate and environmental concerns, such as excessive exploitation of natural resources, inadequate investment in conserva- tion, and insufficient attention to the irreversible loss of certain environmental resources. The authors conclude that, in general, environmental concerns are not best addressed by lowering the discount rate-an action that might have both ben- efits and costs for the environment. A more promising course would be to incorporate a criterion of sustainability into certain aspects of decisionmaking. How such a criterion could be made operational is touched upon but not de- veloped in this article. M any environmentalists fear that the use of discounting in formulating economic policies that will affect the control and use of the earth's natural resources may be against the interests of the natural envi- ronment. They contend that the higher the discount rate, the less long-run The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 137-152 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 137 environmental damage will appear to matter, and the less attractive will invest- ments designed to conserve the environment for future generations appear to be. Furthermore, the resulting accelerated depletion of natural resources will leave those generations with an inadequate natural capital stock to serve their needs. This article examines these concerns and evaluates them systematically. We consider environmental questions in the context of choice through time and discuss whether, and in what way, the future should be discounted in policy areas with a significant environmental dimension. The article begins by describ- ing the rationale for discounting and the main factors that determine the dis- count rate. There is considerable debate within the economics profession as to how relevant or significant each of these factors should be in calculating the rate. Each, moreover, has an environmental dimension. The article goes on to describe and evaluate that dimension. Thus the connection between the basis of discounting and environmental concerns is explored. The connection also works in the other direction-from specific environ- mental issues to the role of discounting within them. The third part of the article deals with this link by examining two important areas where choice of discounting is crucial: projects that will bring irreversible damage to the environment, and policies concerning the management of natural resources in general. Our review of the debate over discounting and the environment leads us to conclude that, although the desire to "do something" to the discount rate for environmental reasons at first sight seems eminently reasonable, it is nearly always unworkable in practice-and often would not be the best solution in any case. Instead, the problem might better be tackled by developing the con- cept of sustainability as a specific policy instrument. The last part of the article describes how that might be done. The Rationale for Discounting The process of discounting can be understood by looking at the familiar mechanism of compound interest. If $1 is invested at 5 percent annually com- pounded, it will be worth $1.63 in ten years time. By the same token, 61 cents invested now, at the same rate of interest, will be worth $1 in ten years time. We would then refer to 0.61 as the present value factor for a ten-year period when the discount rate is 5 percent. Given this direct relation between discount- ing and compound interest, it is evident that the higher the discount rate, the lower the discount factor, and the faster the fall of the discount factor, as the time horizon is extended. The practice of discounting in assessing projects or policies arises because individuals attach less weight to a benefit or cost in the future than they do to a benefit or cost now. Impatience, or "time preference," is one reason; another 138 The World Bank Research Observer, vol. 6, no. 2 (July 1991) is that, since capital is productive, a dollar's worth of resources now will gen- erate more than a dollar's worth of goods and services in the future. Hence an entrepreneur would be willing to pay more than one dollar in the future to acquire a dollar's worth of these resources now. This argument for discounting concerns the "marginal productivity of capital," the use of the word "marginal" indicating that it is the productivity of additional units of capital that is rele- vant. The Choice of the Discount Rate A key instrument of economic policy, the discount rate appears in various guises. As the ruling interest rate underlying the economy, it is a crucial element in the mix of macroeconomic policy measures, such as monetary and public expenditure policy, designed to control inflation and influence savings rates. Private sector discount rates help to determine the amount of private invest- merit. In the extractive sectors, discount rates influence the rate at which nat- ural resources such as oil are depleted. So the choice of discount rate matters very much, and debate about how to choose it has been long and wide ranging. (For industrial countries, see Sen 1967; Marglin 1967; Baumol 1968; Feldstein 1972; and Bradford 1975. For developing countries, see Marglin, Sen, and Dasgupta 1972; Little and Mirrlees 1974; Squire and van der Tak 1975; and Ray 1984.) Excluding questions of risk, which are discussed later, the two main con- tenders for the criterion by which to choose the social discount rate are the social rate of time preference, based on the rate of time preference, and the opportunity cost of capital, based on the marginal productivity of capital. The two rates would be equal if there were efficient markets and no taxes, but in practice time preference rates tend to be below the opportunity cost of cap- ital. The early debate on which rate to use focused on the sources of the funds applied to the project and on the eventual uses of the benefits of the project (Marglin 1967; Feldstein 1972; for a discussion see Pearce and Nash 1981 and Lind 1982). In particular, the extent to which the costs and benefits detracted from, and added to, consumption relative to savings was seen to be crucial in setting the discount rate. In the context of developing countries, additional dif- ficulties arose because not only benefits and costs, but also income to the gov- ernment relative to consumption and investment by the private sector, were valued differently for different points in time.1 These problems have, to some extent, been resolved by two conventions: first, by defining one social group whose benefits or costs are declared to be the "unit of account" and multiplying the benefits or costs of other groups by a conversion factor to obtain compa- rable figures, and second, by using a discount rate that is appropriate for the group whose costs and benefits have been declared the unit of account, or numeraire. Anil Markandya and DavJid W. Pearce 139 A commonly accepted convention, which has been adopted by the World Bank, is to declare uncommitted income in the hands of the government as the unit of account. Then it can be shown that the corresponding discount rate, referred to as the accounting rate of interest, can be approximated by a weight- ed average of the social rate of time preference and the opportunity cost of cap- ital, the weights being the proportions of the yields from the public projects that are, on average, reinvested. (This is a tremendous simplification, derived by a succession of approximations explained in Squire and van der Tak 1975 and Ray 1984.) Although this method has been accepted and the accounting rate of interest has been calculated for many countries, there is still considerable disagreement as to its validity in practice. This can be seen from the fact that, whereas accounting rates of interest are frequently in the range of 4-7 percent, the ac- tual rate used for determining projects funded by the Bank ranges upward from 10 percent. Squire, Little, and Durdag (1979), for example, obtain an account- ing rate of interest for Pakistan of about 2 percent; other, more recent studies have obtained slightly higher figures (about 5-6 percent), but they are still be- low the real rates of 10 percent and more that are currently used for project appraisal within the World Bank. The reasons for these differences are complex and not relevant to this discussion, but it is worth noting that even before en- vironmental issues have been raised, disagreement exists on the choice of the discount rate. In looking at the relation between environmental considerations and discounting, we need, therefore, to consider the arguments for and against various different ways of calculating the rate. Discounting and the Environment In analyzing the relation between environmental concerns and the social dis- count rate, we first reexamine the rationale for discounting and the methods of calculating discount rates in the light of problems peculiar to the environment. Second, we identify and analyze the implications of specific environmental issues. The Rationale for Discounting from an Environmental Perspective The objections to discounting can be conveniently presented under five head- ings: pure time preference; social rate of time preference; opportunity cost of capital; risk and uncertainty; and the interests of future generations. Much of the environmental literature argues against discounting in general and high discount rates in particular (Parfit 1983, Goodin 1986). There is in fact no unique relation between high discount rates and environmental deteri- oration. High rates may well shift the cost burclen to future generations, but as the discount rate rises so the level of investment overall falls, slowing the 140 The World Bank Research Observer, vol. 6, no. 2 (July 1991) pace of economic development in general. Since natural resources are required for investment, the demand for such resources is lower at higher discount rates. High discount rates may also discourage development projects that compete with existing environmentally benign uses-for instance, watershed develop- ment as opposed to existing use of the wilderness. The higher the discount rate, the less attractive are projecits such as dams, in which a large amount of capital has to be expended at the beginning, in return for water or power over a pro- longed period. If the development is avoided, a large area may be saved from inundation, leaving it available-at least in principle-for use in its existing form. In some cases, part of that use is as a forest or as a nature preserve. Ex- actly how the choice of discount rate will influence the use of natural resources or affect the environment is thus ambiguous (Markandya and Pearce 1988, Krautkraemer 1988)-an irmportant point, because it rebuts the simplistic gen- eralization that discount rates should be lowered to accommodate environmen- tal considerations (a prescription already challenged at an intuitive level by Krutilla 1967). PURE INDIVIDUAL TIME PREFERENCE. In terms of personal preferences no one appears to deny the impatience principle and its implication of a positive dis- count rate for individuals. Arguments, do, however, exist against permitting pure time preference to influence social discount rates-that is, the rates used in connection with collective decisions. These arguments can be summarized as follows. First, acting on the impatience principle will not necessarily maximize welfare over the lifetime of an individual (Strotz 1956, Krutilla and Fisher 1975). This is a refinement of the long-standing view that time discounting be- cause of impatience is irrational in general (Jevons 1871, Bohm-Bawerk 1884, Ramsey 1929, Pigou 1932). Second, what individuals want carries no necessary implications for public policy. In many countries, for example, the state com- pels individuals to save-through state pensions, for instance-overriding pri- vate preferences about savings behavior. The third objection is that the underlying value judgment is improperly expressed. A society that puts a premium on the satisfaction of wants should recognize that what matters is the satisfaction of wants as they arise. But this means that it is tomorrow's satis- faction that matters, not today's assessment of tomorrow's satisfaction (Goodin 1986). The validity of these objections to using pure time preference is clearly debatable. Overturning the value judgment fundamental to the liberal econom- ic tradition-that individual preferences should count for social decisions-re- quires compelling reasons. Strong arguments for paternalism do exist, but they are not, in our view, sufficient to justify its use in this context. The third argu- ment, that the basic value judgment needs reexpressing, is philosophically per- suasive, but in practical terms the immediacy of wants in many developing countries where environmental problems are serious argues for the retention of the usual formulation of this basic judgment. Anil Markandya and David W. Pearce 141 SOCIAL RATE OF TIME PREFERENCE. The social time preference rate attempts to measure the rate at which social welfare or utility of consumption falls over time. This will depend on the rate of pure time preference, on how fast con- sumption grows, and, in turn, on how fast utility falls as consumption grows. The social rate of time preference, i, can be expressed (see Ray 1984) by i = ng + z, where z is the rate of pure time preference, g is the rate of growth of real consumption per capita, and n is the percentage fall in the additional utility derived from each percentage point increase in consumption (n is re- ferred to as the elasticity of the marginal utility of consumption). With no growth in per capita consumption, the social rate of time preference would be equal to the private rate, z. If consumption is expected to grow, the social rate rises above the private rate. The intuitive rationale here is that the more one expects to have in the future, the less one is willing to sacrifice today to obtain even more in the future. Moreover, this impact is greater, the faster marginal utility falls with consumption. Environmentalists point to the presumed positive value of g in the formula for the social time preference rate. First, they argue that there are underlying limits to the growth process. We cannot expect positive growth rates of, say, 2-3 percent to last long, because of constraints on natural resources or limits on the capacity of natural environments to act as sinks for waste products. Global warming from the emission of greenhouse gases and the depletion of the ozone layer bear out the seriousness of this concern, but how relevant in practice the "limits" argument is for economic planning is more equivocal- it may have more relevance for the way in which economies develop than as an argument for reconsidering the basic growth objective itself. A second con- cern highlights the problems of particular regions. In low-income Sub-Saharan Africa, for example, real per capita consumption fell 1.9 percent a year between 1973 and 1983. That is, g was negative. Does this mean that the social discount rate should be negative? Arguably, it should, although past negative growth may not be relevant to a discount rate based on expected future growth. More significantly, the pure time preference component of a social discount rate could be argued to be very high. Real borrowing rates in poor economies are often on the order of 10-15 percent and offer a first guess at personal time preference rates. These might then justify the typical rates of 10 percent and more used by lending agencies in the appraisal of projects. Assuming that it is reasonable to use pure time preference rates at all, are these high rates acceptable? Many would contend that the mere presence of poverty predicates high discount rates, because the satisfaction of immediate needs for food is more urgent than the assurance of longer-term food security. But a special difficulty arises when high time preference rates are inferred from the observation of poverty in the context of environmental problems. High dis- count rates can "cause" environmental degradation when short-term measures to satisfy immediate wants foreclose more environmentally appropriate prac- tices such as tree planting-but the environmental degradation leads in turn to 142 The World Bank Research Observer, vol. 6, no. 2 (July 1991) the poverty that "causes" high discount rates. Thus to use these rates to eval- uate environmentally oriented investments (for instance, soil conservation mea- sures and afforestation) is untenable. These considerations suggest that the use of a social rate of time preference based on the assumptions expressed in the equation is valid only when we can reliably expect sustainable changes in real consumption per capita. In situations in which the environment is being degraded and incomes are stagnant or fall- ing, inferred values of z cannot be taken as relevant to the calculation of i. In these circumstances there are no clear rules for choosing a social rate of time preference, although one could argue strongly that the value of i should be adjusted downward. OPPORTUNITY COST OF CAPITAL. The opportunity cost of capital is obtained by looking at the rate of return on the best investment of similar risk that is displaced as a result of undertaking the project in question. It is only reasonable to require an investment to yield a return at least as high as that on the alter- native use of funds. This is the justification for a discount rate based on op- portunity cost. In developing countries where there is a shortage of capital, such rates tend to be very high and their use is often justified on grounds of optimal allocation of scarce capital. (Markandya and Pearce 1988 give exam- ples of how scarce capital can in fact be allocated without making adjustments to the discount rate. What is required is that a premium be attached to capital such that each dollar invested has a value greater than one dollar in the project calculations.) The environmental literature has made some attempts to discredit opportu- nity cost discounting (Parfit 1983, Goodin 1986). One criticism is that oppor- tunity cost discounting implies a reinvestment of benefits at the opportunity cost rate, and this is often invalid. For example, at a 10 percent discount rate, $100 today is comparable to $121 in two years' time if the $100 is invested for one year to yield $10 of return and then both the original capital and the return are invested for another year to obtain a total of $121. Now, if the return is consumed but not reinvested, the critics argue, the consumption flows have no opportunity cost. What, they say, is the relevance of a discount rate based on assumed reinvested profits if in fact the profits are consumed? The idea that the mix of consumption and reinvestment benefits flowing from the investment should modify the underlying discount rate is familiar to economists. It pro- vides one of the rationales for the weighted discount rate procedures advocated by Marglin (1967) and has been widely discussed in the literature. Another environmentalist criticism of opportunity cost discounting relates to compensation across generations. Suppose an investment today would cause environmental damages valued at $x, T years from now. In discounted terms this damage would be represented by an amount much less than x. How much less would depend on how high the discount rate r was and on how large T was. The argument for using this smaller figure instead of x is the following. Anil Markandya and David W. Pearce 143 If this latter amount were invested at the opportunity cost of capital discount rate r, it would amount to $x in T years' time. This could then be used to com- pensate those who suffer the damages in that year. Parfit (1983) argues, how- ever, that using the discounted value is only legitimate if the compensation is actually paid. Otherwise, he argues, we cannot represent those damages by a discounted cost.2 The problem here is that actual and potential compensation are being con- fused. The fact that there is a sum generated by the project that could be used to compensate the victim is enough to ensure its efficiency. Whether the com- pensation should actually be carried out is a separate question irrelevant to the issue of how to choose a discount rate. These two arguments against opportunity cost discounting are not, in our view, persuasive, although the first can be argued to be relevant to a weighted approach. RISK AND UNCERTAINTY. It is- widely accepted that a benefit or cost should be valued less the more uncertain is its occurrence. The types of uncertainty gen- erally regarded as relevant to discounting are the risk-of-death argument (un- certainty about whether an individual will be alive at some future date); uncertainty about what the individual's preferences will be in the future; and uncertainty about the size of the benefit or cost. The risk-of-death argument is often used to justify the impatience principle itself, the argument being that a good reason for preferring consumption now rather than later is that one may not live to enjoy the fruits of one's restraint. The counter-argument is that whereas an individual is mortal, society is not, and so its decisions should not be guided by considerations of mortality. This is another variant on the view that, in calculating social time preference rates, the pure time preference element z may be too high. Second, uncertainty about the future preferences of individuals is relevant to certain goods and perhaps even to certain aspects of environmental conserva- tion. It is surely not relevant when the benefits of the projects or policies in question are food, shelter, water, and energy. If anything, future preference for these goods is more certain, not less (Barry 1977). Moreover, in cases in which concern about uncertain future preferences is legitimate, economists generally allow for the uncertainty by including option value-that is, the value of reducing future uncertainty-in an estimate of the benefit or cost (Bishop 1982, Fisher and Haneman 1986). The third kind of uncertainty is relevant, but adjusting the discount rate to allow for it poses problems. Such adjustments assume that the scale of risks is increasing exponentially over time, and since there is no reason to believe that the risk factor takes this particular form it is inappropriate to correct for such risks by raising the discount rate. This argument is accepted by economists (Dasgupta and Pearce 1972, Stiglitz 1986) but the practice of using risk-adjust- ed discount rates remains common among policymakers. For example, there is 144 The World Bank Research Observer, vol. 6, no. 2 (July 1991) a 2 percent premium attached to the officially recommended 5 percent "test dis- count rate" in the United Kingdom in the presence of "benefit optimism" (U.K. Treasury 1980). This means that if the project has benefits that are considered to be uncertain, such as a new electric energy system involving development, a test discount rate of 7 percent instead of 5 percent is applied. Of course, the decision of what is uncertain is itself rather arbitrary in this context. If uncertainty is not to be handled by adjustments in the discount rate, how should it be treated? The alternative is to make adjustments to the underlying cost and benefit streams. This essentially involves replacing each uncertain ben- efit or cost by its certainty equivalent-a procedure that seems to us to be correct, even though the calculations involved are complex and it is not yet clear how operational the method is. In any case, whatever the drawbacks to the alternative procedure, adding a risk premium to the discount rate is not the solution because, as has been shown by Brown (1983) and Prince (1985), the use of such a premium implies the existence of arbitrary certainty equiva- lents for each of the costs and benefits. THE INTERESTS OF FUTURE GENERATIONS. The extent to which the interests of future generations are safeguarded by using positive discount rates is a mat- ter of debate within the literature. With overlapping generations, borrowing and lending can arise as soime individuals save for their retirement and others dissave to finance consumption. Models constructed to take this phenomenon into account have shown (I)iamond 1965) that the discount rate that emerges is not necessarily efficient--that is, it is not the one that takes the economy on the path to maximum long-run welfare. These models, however, lack the com- ponent of altruism. Altruism is said to exist when the utility of the current gen- eration is influenced not only by its own consumption but also by the utility of future generations. This is modeled by assuming that the utility of the cur- rent generation-generation i-is also influenced by the utility of the second generation j and the third generation k. This approach goes some way toward tackling the question of future generations, but it does so in a rather narrow way. What is being evaluated here is the current generation's judgment about what future generations will think is important. It does not therefore yield a discount rate that reflects some broader principle of the rights of future gener- ations. The essential distinction is between generation i judging what genera- tions j and k want (selfish altruism) and generation i engaging in such use of resources as to leave j and k with the maximum scope for choosing what they want (disinterested altruisnm) (Page 1977). And it is not only the extent and na- ture of the overlap that are important but also the time horizon of the deci- sionmaker, who may not reflect the preferences of the individuals with respect to future as opposed to present consumption. Although this form of altruism is recognized as important, its implications for the interest rate and the efficiency of that rate have yet to be worked out. Anil Markandya and David W. Pearce 145 Some work in this direction is under way and has been referred to by Becker (1988). The validity of the overlapping generations argument has also been ques- tioned on the grounds of the roles individuals are playing when they look at future generations' interests. Individuals make decisions in two contexts-pri- vate decisions reflecting their own interests and public decisions in which they act with responsibility for fellow beings and for future generations. Market dis- count rates, it is argued, reflect the private context, whereas social discount rates should reflect the public context. This is what Sen (1982) calls the "dual role" rationale for social discount rates being below the market rates. It resem- bles the argument that people will behave differently if they can be assured that their own action will be accompanied by similar actions by others. Thus we might each be willing to make transfers to future generations, only if we are individually assured that others will do the same. The "assured" discount rate arising from collective action is lower than the "unassured" rate. Two other arguments used to justify the idea that market rates will be too high for the interests of future generations are what Sen (1982) calls the "super responsibility" argument and the "isolation paradox" (Sen 1961, 1967). The first contends that, since market discount rates arise from the behavior of in- dividuals, whereas the state is a separate entity with the responsibility for guarding collective welfare and the welfare of future generations, the rate of discount relevant to state investments will not be the same as the private rate and, since high rates discriminate against future generations, we would expect the state discount rate to be lower than the market rate. The second is rather similar to that generated by the assurance problem but arises from slightly dif- ferent considerations. The argument is that when individuals cannot capture the entire benefits of present investments for their own descendants, the private rate of discount will be below the social rate. Hence, for a variety of reasons relating to future generations' interests, the social discount rate may be below the market rate. The implications for the choice of the discount rate are that there is a need to look at an individual's public behavior, or to leave the choice of the discount rate to the state, or to try and select a rate based on a collective savings contract. None of these options, however, offers a practical procedure for determining the discount rate in quantitative terms. What they do suggest is that market rates will not be proper guides to social discount rates once future generations' interests are in- corporated into the social decision rule. These arguments can be used to reject the use of a market-based rate if it is thought that the burden of accounting for future generations' interests should fall on the discount rate. However, this is a complex and almost certainly untenable procedure. It may be better to re- tain the conventional criteria for determining the discount rate (that is, the in- terests of the current generation) and to define and use the rights of future generations to circumscribe the overall evaluation. Such an approach is illus- trated shortly. 146 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Discount Rates and Specific Environmental Issues So far we have looked alt the rationale for discounting and the debate on the choice of the discount rate from an environmental perspective. In this sec- tion we look at specific environmental issues and see how they are affected by the discounting process. The issues considered are irreversible damage and the management of natural resources. IRREVERSIBLE DAMAGE. One special environmental consideration that might, prima facie, seem to argue for the adjustment of the discount rate is that of irreversibility. As the term implies, the concern is with decisions whose out- come cannot be reversed, such as the flooding of a valley, the destruction of ancient monuments, the disposal of radioactive waste, and the loss of trop- ical forests. These considerations have been incorporated in a cost-benefit methodology by Krutilla and Fisher (1975) and generalized by Porter (1982). We outline the basic ideas below. Consider a valley containing a unique wilderness area, in which a hydroelec- tric development is being proposed. The area, once flooded, would be lost for- ever and these forgone benefits are clearly part of the costs of the project. The net benefits of the whole scheme are the total benefits, less the total costs of the development, less the net benefits of preservation (that is, benefits of pres- ervation less any costs of preservation). All the benefits and costs need to be expressed in present value terms. The irreversible loss of the preservation ben- efits might suggest that the discount rate should be set very low, since it would have the effect of making the net benefits of preservation relatively large because these extend over an indefinite future. Since the benefits of develop- ment extend over only a finite period (say fifty years) the effect of lowering the discount rate is to lower the net benefits of the project. But Krutilla and Fisher do not adjust the discount rate; they treat it conventionally-that is, they set it equal to some measure of the opportunity cost of capital. Instead of adjusting the discount rate, Krutilla and Fisher note that the value of benefits from a wilderness area will grow over time-because the supply of such areas is shrinking, the demand for their amenities is growing with income and population growth, and the demand to have such areas preserved even by those who do not intend to use them is growing (that is, what are referred to as existence values are increasing). The net effect is to raise the "price" of the wilderness at some annual rate of growth (say g percent). If the price is growing at a rate of g percent and a discount rate r percent is applied to it, this is equiv- alent to holding the price constant and discounting the benefit at a rate (r - g) percent. The adjustment is very similar to lowering the discount rate but has the attraction that the procedure cannot be criticized for distorting resource allocation in the economy by using variable discount rates. Krutilla and Fisher engage in a similar but reverse adjustment for the benefits of development. They argue that technological change will tend to reduce the Anil Markandya and David W. Pearce 147 benefits from developments such as hydropower because superior electricity- generating technologies will take their place over time. The basis for this argu- ment is less clear, but, if one accepts it, the benefits of development are subject to technological depreciation. Assume this rate of depreciation is k percent. Then the effect is to produce a net discount rate of (r + k) percent, thereby lowering the discounted value of the benefits of development. THE MANAGEMENT OF NATURAL RESOURCES. The crucial decision for the management of natural resources is how much to consume now and how much to hold in store for future consumption. It is intuitively clear that this decision will be influenced by the price of present as opposed to future consumption- that is, by the discount rate. The full analysis of the relation between the discount rate and the pattern of exploitation of natural resources is complex (see Clark 1990); the relevant point is that the higher the discount rate, the fast- er the depletion of an exhaustible resource and the more intense the harvesting of a renewable resource.3 This means that exhaustible resources will be deplet- ed more quickly and smaller stocks of renewable resources will exist at higher discount rates. Moreover, the combination of high discount rates with high ra- tios of price to cost for harvesting can lead to "optimal" extinction of the resource (Clark 1990). These features of the use of natural resources have several implications for their management. The first is that investments in the resource-exploiting ac- tivity need to pay special attention to the effects of discount rates on the time profile of benefits and costs. For example, if there are two projects, one of which exhausts a resource in ten years and another in twenty-five years, then the higher the discount rate, the more likely it is that the former will be chosen over the latter. High discount rates can exist for a number of reasons, such as anti-inflationary monetary policy or capital rationing. They may be fully justi- fied in those contexts but may have undesirable consequences for projects in- volving natural resources. The exploitation of natural resources will also be excessive if the private dis- count rate is higher than the social rate and the control of the resource is in private hands. Methods for correcting this overexploitation have been discussed extensively elsewhere (Pearce forthcoming; Repetto, McGarth, and Wells 1986). In general, however, these do not involve changing the private rate of discount. The reasons for this rate being too high are pervasive in the whole economy, and the rate itself is not easily manipulated. Resources can be con- served by the appropriate use of resource taxes, which allow the government to capture more of the rent arising from the development of resources. Apart from slowing this development where desirable, resource taxes also have the advantage of mobilizing funds for the government in a particularly efficient way. For all the reasons discussed, any special lowering of discount rates for nat- ural resource projects is unlikely to be desirable. Furthermore, practical diffi- 148 The World Bank Research Observer, vol. 6, no. 2 (July 1991) culties arise if some projects are to be treated as special and others not. There is the question of which projects should qualify. Inevitably there will be gray areas that will cause further problems. Second, many decisions about the ex- ploitation of resources are made privately, and it is not practicable to change discount rates for private individuals in one field of activity alone. Third, even if lower discount rates were used, there is no guarantee that some serious re- source degradation might not occur. Sustainability The environmental debate has undoubtedly contributed to valuable intellec- tual soul-searching on the rationale for discounting. But, in our view, it has not made the case for rejecting discounting as such. We began by examining the concern over the use of discount rates that reflect pure time preference, but con- cluded that this disquiet does not provide grounds for rejecting pure time pref- erence completely. We notecl, however, that an abnormally high time preference rate can be generated when incomes are falling and when environmental deg- radation is taking place. In these circumstances, it is inappropriate to apply discount rates based on these high rates of time preference to policies, partic- ularly environmentally relevant ones. The arguments by environmentalists against the use of opportunity cost of capital discount rates were also, in general, not found to be persuasive. To ac- count for uncertainty in the appraisal of investments, it is preferable to adjust the cost and benefit streams for the uncertainty rather than to add a risk pre- mium onto the discount rate. Finally, under the general reanalysis of the ratio- nale for discounting, we examined the arguments for adjusting discount rates on various grounds of intergenerational justice. Although many of these argu- ments have merit, we concluded that adjusting the discount rate to allow for them was not, in general, a practicable or efficient procedure. But the need to protect the interests of future generations remains paramount in the environ- mental critique of discounting (Feinberg 1980, Goodin 1986), and some alter- native policy is therefore required if the route of adjusting the discount rate is not to be followed. One possibility is a policy that recognizes the constraints imposed by the need for sustainability. The notion of sustainability, or sustainable development, is widely discussed in WCED (1987). Few attempts have been made to analyze the concept rigor- ously (Pezzey 1989; Pearce, Barbier, and Markandya 1989), but the basic idea is that economic development requires a strong policy of protecting the natural resource base-in other words, that the resource base should be maintained in- tact in some sense, or even enhanced. The link between maintaining the overall capital base of the economy (both manmade and "natural" capital) and inter- generational equity is established in some of the recent literature (Solow 1986). Advocates of sustainability go further and separate out natural capital for Anil Markandya and David W. Pearce 149 special attention. In the developing world one justification for this would be the close dependence of large parts of the population on natural capital (soil, water, and biomass). More generally, ecological science suggests that much natural capital cannot be substituted for by manmade capital (an example might be the ozone layer). Other rationales are given in Pearce, Barbier, and Markandya (1989). If conservation of natural environments is a condition of sustainability, and if sustainability answers many (perhaps all) of the valid criticisms of discount- ing, how might sustainability be built into the appraisal of projects? Requiring that no project should contribute to environmental deterioration would be ab- surd. But it is not absurd to require that the portfolio of projects as a whole should not contribute to environmental deterioration. One way to meet the condition of sustainability is to require that any environmental damage be com- pensated by projects specifically designed to improve the environment. Intro- ducing this additional sustainability constraint on projects has some interesting implications for their design and selection (Pearce, Barbier, and Markandya 1989). One of these is that the choice of discount rate no longer becomes a key issue as far as the protection of the environment is concerned. It can then func- tion as a mechanism for allocating scarce resources to investment, which has always been its primary role. There are many unanswered questions about how a criterion of sustainability would operate and what its implications would be-and these could be quite radical. In view of its importance, however, it should be a priority to investigate the operational possibilities of the criteri- on. This would be preferable to attempting to adjust the discount rate to ac- count for the complex environmental concerns that arise in economic development. Notes Anil Markandya is a reader and David W. Pearce is a professor in the Department of Eco- nomics of University College, London. 1. The consumption weight could also vary according to the income level of the recipient. Such "distributional" weights are frequently referred to in theory but are rarely used in practice. 2. Similar, but more extreme, is the position of one of the referees to this article, who has argued that calculating present values in which the allocations that accrue to different people are discounted and added up is invalid, because the latter is a distributional issue and cannot be addressed through the use of a discount rate. But taking this argument to its logical conclusion would also imply that we could not add up benefits or costs across individuals even at a point in time, which is a familiar distributional difficulty in cost-benefit analysis but one that can be and has been surmounted in various ways. 3. In fact, the relation between discount rates and the optimal extraction path can be quite unintuitive and even perverse. As Chapman (1986) and Rowse (1988) have shown, paths that are very close to being optimal can be unexpectedly divergent, and their distributional implications could be very different. Thus it could be difficult to choose between paths on the grounds of optimality alone in the presence of discounting, and it may be necessary to invoke other consid- erations, such as equity. 150 The World Bank Researcb Observer, vol. 6, no. 2 (July 1991) References The word "processed" describes informally reproduced works that may not be commonly available through libraries. Barry, Brian. 1977. 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Mathematical Bioeconomics: The Optimal Management of Renewable Resources. 2d ed. New York: Wiley. Dasgupta, Ajit K., and David W. Pearce. 1972. Cost-Benefit Analysis: Theory and Practice. London: Macmillan. Diamond, P. A. 1965. "National Debt in the Neoclassical Growth Model." American Economic Review 55: 1125-50. Feinberg, Joel. 1980. Rights, Justice and the Bounds of Liberty. Princeton, N.J.: Princeton Uni- versity Press. Feldstein, Martin. 1972. "The Inadequacy of Weighted Discount Rates." In Richard Layard, ed., Cost Benefit Analysis. Harmondsworth, U.K.: Penguin. Fisher, Anthony C., and W. M. Haneman. 1986. "Environmental Damages and Option Values." Natural Resources Modelling 1: 111-24. Goodin, Robert E. 1986. Protecting the Vulnerable. Chicago: University of Chicago Press. Jevons, William. 1871. The Theory of Political Economy. London: Macmillan. Krautkraemer, J. A. 1988. "The Rate of Discount and the Preservation of Natural Environ- ments." Natural Resources Modelling 2 (3): 421-38. Krutilla, John V. 1967. "Conservation Reconsidered." American Economic Review 57: 777-86. Krutilla, John V., and Anthony C. Fisher. 1975. The Economics of Natural Environments. Washington, D.C.: Resources for the Future. Lind, Robert C. 1982. "A Primer on the Major Issues Relating to the Discount Rate for Evalu- ating National Energy Options." In Robert C. Lind, ed., Discounting for Time and Risk in Energy Policy. Baltimore, Md.: Johns Hopkins University Press. Little, Ian M. D., and J. A. Mirrlees. 1974. Project Appraisal and Planning for Developing Coun- tries. London: Heinemann. Marglin, Stephen A. 1967. Public Investment Criteria. London: Allen & Unwin. Marglin, Stephen A., A. Sen, and P. Dasgupta. 1972. Guidelines for Project Evaluation. Vienna: United Nations Industrial Development Organization. Markandya, Anil, and David W. Pearce. 1988. "Environmental Considerations and the Choice of the Discount Rate in Developing Countries." Environment Department Working Paper 3. WVorld Bank, Washington, D.C. Processed. Page, Talbot. 1977. "Equitable Use of the Resource Base." Environment and Planning, ser. A, 9: 15-22. Anil Markandya and David W. Pearce 151 Parfit, Derek. 1983. "Energy Policy and Further Future: The Social Discount Rate." In D. MacLean and P. Brown, eds., Energy and the Future. Totowa, N.J.: Rowman and Littlefield. Pearce, David W. Forthcoming. "Foundations of an Ecological Economics." Ecological Model- ling. Pearce, David W., E. Barbier, and Anil Markandya. 1989. Sustainable Development: Economics and Environment in the Third World. London: Elger Publishing. Pearce, David, and C. A. Nash. 1981. The Social Appraisal of Projects. London: Macmillan. Pezzey, J. 1989. "Economic Analysis of Sustainable Growth and Sustainable Development." Environment Department Working Paper 15. World Bank, Washington, D.C. Processed. Pigou, Arthur C. 1932. The Economics of Welfare. London: Macmillan. Porter, Richard. 1982. "The New Approach to Wilderness Preservation through Benefit-Cost Analysis." Journal of Environmental Economics and Management 9: 59-80. Prince, Raymond. 1985. "A Note on Environmental Risk and the Rate of Discount: Comment." Journal of Environmental Economics and Management 12: 179-80. Ramsey, E P. 1929. "A Mathematical Theory of Saving." Economic Journal 38: 543-59. Ray, Anandarup. 1984. Cost-Benefit Analysis: Issues and Methodologies. Baltimore, Md.: Johns Hopkins University Press. Repetto, Robert, William McGarth, and Michael Wells. 1986. Natural Resource Accounting in a Resource Based Economy: An Indonesian Case Study. Washington, D.C.: World Resources Institute. Rowse, John. 1988. "Does an Exhaustible Resource Usually Have Many Near Optimal Paths?" American Journal of Agricultural Economics 70 (3): 646-53. Sen, A. K. 1961. "On Optimizing the Rate of Saving." Economic Journal 71: 479-96. - . 1967. "Isolation, Assurance, and the Social Rate of Discount." Quarterly Journal of Eco- nomics 81: 112-24. . 1982. "Approaches to the Choice of Discount Rates for Social Benefit-Cost Analysis." In Robert C. Lind, ed., Discounting for Time and Risk in Energy Policy. Baltimore, Md.: Johns Hopkins University Press. Solow, Robert M. 1986. "On the Intergenerational Allocation of Natural Resources." Scandina- vian Journal of Economics 88: 141-49. Squire, Lyn, and Herman van der Tak. 1975. Economic Analysis of Projects. Baltimore, Md.: Johns Hopkins University Press. Squire, Lyn, Ian M. D. Little, and Mere Durdag. 1979. Application of Shadow Pricing to Country Economic Analysis with an Illustration from Pakistan. World Bank Staff Working Paper 330. Washington, D.C. Stiglitz, Joseph E. 1986. Economics of the Public Sector. New York: Norton. Strotz, R. 1956. "Myopia and Inconsistency in Dynamic Utility Maximization." Review of Eco- nomic Studies 23 (3): 165-80. U.K. Treasury. 1980. Investment Appraisal and Discounting Techniques and the Use of the Test Discount Rate in the Public Sector. London. WCED (World Commission on Environment and Development-the Bruntland Commission). 1987. Oxford: Oxford University Press. 152 The World Bank Researcb Observer, vol. 6, no. 2 (July 1991) REACHING THE RURAL POOR THROUGH PUBLIC EMPLOYMENT Arguments, Evidence, and Lessons from South Asia Martin Ravallion With the limited set of policy instruments typically available in the rural sec- tors of developing countries, imperfect coverage of the poor and leakage to the nonpoor must be expected from even the most well-intentioned poverty allevi- ation scheme. One way to reach the poor more effectively is to build incentives for self-selection into the scheme. Labor-intensive rural public works projects have the potential to reach and protect the poor, as well as to create and main- tain rural infrastructure. The limited evidence for South Asia suggests that few nonpoor persons want to participate, and that both direct and indirect transfer and stabilization benefits to the poor can be sizable. These benefits can, how- ever, be rapidly dissipated by a badly conceived and executed project; the de- tails of how projects are selected, designed, and financed are crucial to success in both the short and the long run. U nder the right conditions, economic growth can be a powerful weapon against absolute poverty. But the initial conditions are often less than ideal, and the fruits of growth are often less than equitable. It may therefore take a long time to bring the poorest up to adequate consumption levels. Many governments will want to intervene directly to increase the pace at which poverty is reduced. But direct interventions to alleviate poverty in the short run may well involve significant costs against other policy objectives: in particular, an unfortunate but real tradeoff between helping today's poor as opposed to tomorrow's poor The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 153-175 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 153 (World Bank 1990). The terms of the tradeoff are influenced by the efficiency of the interventions. Different policy options may have different effects on pov- erty for the same resource cost (or may achieve the same reduction in poverty at different costs). This article surveys theory and evidence relevant to assessing the scope for reducing poverty through rural employment schemes, financed from public revenues. Such schemes have been used or advocated for centuries, and there is a large literature on them, particularly for South Asia. The aim here is not to survey that literature, but rather to illuminate the underlying analytical ar- guments and their relevance to policy. An Overview of the Policy Problem This section discusses the objectives and constraints relevant to evaluating schemes for the alleviation of income poverty, giving emphasis to problems with incentives and information that routinely confound attempts to reach the rural poor directly. Objectives The desire to alter the distribution of living standards is an important motive for policy intervention. One criterion by which we judge whether that distri- bution has improved is whether minimal needs of individuals for nutrition and other essential forms of consumption have been met. Our concern here is with a class of policies whose main aim is to raise incomes of the poor rapidly, for which a sacrifice of other social objectives is to be expected.1 Resources are available to alleviate poverty; how should they be allocated? In principle, any scheme to alleviate poverty has both transfer benefits and stabilization benefits for the poor. The transfer benefits can be both direct- the gross benefit to participants less any cost they incur in participating-and indirect-including the share of the poor in the extra income generated by the scheme's outputs, and any other second-round effects on income from other sources. The stabilization benefits arise mainly frorn the scheme's effect on the risk facing the poor of a decrease in consumption. Plainly, the benefits of any policy that lessens down-side risks of those near the edge of survival must be valued very highly. Both transfer and stabilization benefits should be considered in evaluating these schemes. In defining objectives and evaluating outcomes we may need to be precise about the meaning, and measurement, of poverty. In some instances, a ranking of the distributions of income before and after a policy reform suffices. The subtleties of measuring poverty would then be irrelevant. But some difficult pol- icy issues rest on assumptions (including ethical value judgments) embodied in various measures of poverty. There is an important distinction between the con- 154 The World Bank Research Observer, vol. 6, no. 2 (July 1991) cern about the prevalence of poverty, as measured by the number or proportion of poor, and about the depth or severity of poverty, which also considers how living standards are distributed below the poverty line. The judgments made about issues of measurement can have bearing on policy choices. Constraints We should not underrate either the political or the economic constraints that confront attempts to raise the level or reduce the variability of consumption by the poor. Some of those constraints are obvious, but that does not mean they are easy to assess. The budget constraint is a case in point. The resources em- ployed in a rural public works scheme should ideally be valued at their social opportunity cost-that is, their cost in terms of forgone benefits to society. Market prices need not be a good guide; indeed the impetus for a rural public works scheme is often the existence of involuntary underemployment in lean agricultural seasons, so that market wage rates do not reflect the opportunity cost of the labor employed on the scheme. Given the potential importance of these schemes for income insurance, the relevant budget constraint should relate to the long-term level of expenditure rather than to current levels in any one year. Year-to-year fluctuations in out- lays reflect the scheme's important function in stabilizing the incomes of the poor. In practice, however, even governments can face short-term liquidity con- straints, which may inhibit the scheme's performance. Constraints on adminis- trative capability may alsco arise in dealing with fluctuating outlays. The constraints on instruments available to policymakers are no less impor- tant. The set of policy instruments available for the alleviation of poverty is often quite restricted in developing countries-particularly in rural areas, where the highest concentrations of absolute poverty are generally found (World Bank 1990). Such real world constraints have led some observers to ar- gue that, by one means or another, the benefits of official development pro- grams have gone mainly to the nonpoor, helped by government officials whose own interests are well served by that outcome. (Examples can be found in Hartmann and Boyce 1983, Hirway 1986, Hossain 1985, Dreze 1988, and Dreze and Sen 1989.) With perfect information on individual earning ability, and a cooperative ad- ministrator, one can precisely identify the poor and target transfers accordingly. A means test can then be used to screen the poor from the nonpoor. In these circumstances, there would be no place for a rural public works scheme as part of a strategy to alleviate poverty; it would be more cost-effective simply to give money to the poor than to insist that they forgo other income to obtain relief. The effect on poverty is then constrained only by the available budget. However, administering a means test is simply not feasible in the rural areas of most developing countries. The cost of obtaining information on indi- vidual incomes would be prohibitive; at best, one can hope to identify some Martin Ravallion 155 approximate indicators of poverty, such as landlessness or place of residence (Ravallion 1989; Datt and Ravallion 1990; for a survey of the evidence, see Ravallion 1990a). Moreover, the administrative agent's objectives-which need not coincide with those of the policymaker-and efforts at implementation- which may be hard to monitor-entail further constraints. Thus policymakers must contend with imperfect information both on the true living standards of potential recipients and on the performance of inter- vening agents. In such circumstances the best course available for redistributive intervention may entail costs for would-be participants that, in a "first-best world" of perfect information and unrestricted policy instruments, would be deadweight losses (Nichols and Zeckhauser 1982, Roberts 1984, Blackorby and Donaldson 1988, Besley and Coate 1988). The following section reviews these arguments. Incentives for Improved Targeting One way to improve targeting is to impose costs on would-be participants that vary implicitly as some increasing function of their (unobserved) incomes. A work requirement, for example, imposes the cost of forgone income on par- ticipants, and one would expect that cost to be lower for the poor. The level of the gross benefit to participants, however, is generally independent of income (since the policymaker cannot know incomes in this setting). Thus people with incomes above some critical level (which may vary with other personal char- acteristics) do not want to participate. The monetary cost of participation should not be too high at low incomes, or the net gains to the poor become so low that it would be more cost-effective simply to make untargeted transfers. Once participation costs to the poor are considered, even a scheme that is very successful in screening the poor may be a less cost-effective way of alleviating poverty than poorly targeted alterna- tives.2 That is an empirical question. The performance of the scheme may also depend on the influence of inter- vening agents over participation. Discretion in the selection of beneficiaries by local administrators may improve targeting (by exploiting further information on characteristics of desired participants) or worsen it (by allowing agents to extract rents). The outcome is determined by the preferences and incentives fac- ing the agent. The cost imposed on recipients at any given income level and the discretion given to agents in selecting recipients among those who are willing to incur that cost are thus key variables influencing the scheme's performance. Both can be influenced by policy design. Two incentives to avoid leakage that can be built into a scheme are (1) a penalty system to deter people from misrepresenting information and (2) work requirements to discourage participation by the nonpoor. Like means testing, effective penalty systems can be costly to administer in developing countries 156 The World Bank Research Observer, vol. 6, no. 2 (July 1991) and are therefore rare. The usefulness of work requirements in screening the poor, however, has long been recognized. The nineteenth-century Poor Law in England used this device, as did the famine relief codes in British India. The information needed from recipients is simply their willingness to work at the wage rate offered. Relief is thus allocated on the basis of the worker's "reser- vation wage rate"; only those with a reservation wage less than the offered wage will volunteer. For such a scheme to be effective, the correlation between the reservation wage rate and the standard of living of the worker's household must be high enough; if it is too low, it would again be more cost-effective sim- ply to make untargeted transfers. It is not obvious a priori that such schemes will perform well in reaching the poor. Social stigma might discourage or physical incapacity might debar some from doing the work. Furthermore, some of the nonpoor (with relatively high unearned incomes, for example) might well be willing to participate, and they will probably benefit in other ways, through extra income derived from the assets created, or through underpayment of workers by corrupt managers. Even if the poor are screened well, forgone incomes may be so large as to make alternative policies more cost-effective. Later sections will examine empirical evidence bearing on these issues. Considerations of Political Economy Two distinct aspects of the political economy of schemes to alleviate poverty bear directly on policy constraints. First, from casual observation it appears that the generosity of those financing the scheme is influenced by its design and performance. Altruistic donors who know that their money is reaching the poor will probably be more forthcoming; if work requirements make this more likely, they will generate larger budgets. It is also thought that generosity is sometimes stimulated by the knowledge that beneficiaries will have to work for their money and that donors require reassurance that the recipients will not be made so much better off in utility terms that they are discouraged from taking actions that would help them escape poverty in the future (see Besley and Coate 1988). A second argument applies to donors and supporters whose financial and political support is not altruistic but depends on the benefits they personally derive. Any scheme to alleviate poverty is likely to have benefits for the non- poor, ranging from direct participation in an imperfectly targeted scheme to benefits from assets created. A public works project, for instance, creates assets whose benefits can be far more widely distributed than the wages of partici- pants. This has been a factor in the political acceptance among the rural rich of Maharashtra's Employrnent Guarantee Scheme (EGS) (Herring and Edwards 1983). So better targeting can actually be a mixed blessing for the poor- schemes with wider coverage often permit the formation of coalitions that allow greater political support than the poor alone could muster for a targeted Martin Ravallion 157 program. Thus targeting may be more cost-effective but less sustainable polit- ically (Besley and Kanbur 1990, Dreze and Sen 1989). In risky environments, the terms of any tradeoff between cost-effectiveness and political feasibility are likely to favor self-targeting schemes that build in the right of universal coverage-anyone can participate, though not all will want to. For example, incomes can vary considerably over time in economies based on agriculture, and rarely do all move in the same direction, at least over a wide enough area. The set of potential participants in a rural public works scheme may then be far larger than that of actual participants at any one date-and this situation provides a wider base of political support for the scheme as insurance for an uncertain future. A case in point is the employment guarantee of the Maharashtra scheme, which appears to have encouraged effective political solidarity among the state's rural poor and near-poor (Echeverri-Gent 1988). This by no means guarantees political feasibility, but it undoubtedly helps. Do Rural Public Works Schemes Reach the Poor? The disappointing performance of targeting that uses readily available indi- cators of poverty (such as region of residence and landholding class) has mo- tivated interest in self-targeting schemes such as rural public employment.3 There is, however, surprisingly little useful quantitative evidence on the perfor- mance of incentive schemes for self-targeting. Sorne attempts have been made to quantify the effect of rural public works schemes on poverty, but these have been based on ad hoc assumptions about their performance in screening the poor (see, for example, Narayana, Parikh, and Srinivasan 1988; Parikh and Srinivasan 1989). The following section surveys evidence on the targeting per- formance of two large schemes in South Asia. Targeting Performance The Maharashtra Employment Guarantee Scheme provides unskilled manu- al labor on small-scale rural public works projects, such as roads, irrigation facilities, and reforestation. The EGS was introduced during the severe drought of 1970-73 and expanded rapidly to reach average monthly participation of about 500,000 persons over the period 1975-89. In a typical year the scheme provides about 100 million person-days of employment in a state with a rural work force (including cultivators) of about 20 million persons, though we do not know the figure net of displaced employment. Bangladesh's Food for Work Programme (FFWP) was introduced soon after the 1974 famine, although a rural works program had existed since the 1960s. The F]FWP has grown considerably since then, providing about 100 million days of labor in 1987-88. The scheme 158 The World Bank Research Observer, vol. 6, no. 2 (July 1991) organizes and pays (in kind) for construction and maintenance of irrigation, drainage, and embankment projects. There has been much debate about how effectively Maharashtra's EGS has reached the rural landless. Dandekar and Sathe (1980) estimated that the scheme eliminated three-quarters of unemployment among landless or near landless households in 1977-78. Under more conservative assumptions Osmani (1988) argued that the scheme could not have eliminated more than one-third of this group's unemployment. The Planning Commission's report on the EGS (PEO 1980) was critical of the scheme's targeting performance, on the grounds that there was significant participation by small farmers, as well as the landless. Much of this debate has missed the point. It is the poor whom we are trying to reach, not the landless per se. And, although the correlation between poverty and landlessness is high, it is far from perfect (Dandekar and Rath 1971, Sharma 1985, Ravallion 1989). A similar comment applies to the relation between poverty and unernployment (Visaria 1981) and to assessments of re- gional targeting (Datt and Ravallion 1990). More direct evidence on targeting is needed. A better test is to compare the distribution of income among participants with that for the rural population as a whole. Despite well-known difficulties in assessing incomes in this context, four surveys that made the attempt can be used to throw light on how well the schemes have performed in reaching the poor. Three are for the EGS; the fourth is for Bangladesh's FFWP. Dandekar and Sathe (1980) report that 90 percent of workers in their 1978-79 survey of 1,500 EGS participants spread over fifty-six projects were liv- ing below the poverty line. (Note that this calculation includes the EGS earnings of participants; the proportion of participants who were poor must have been even higher before the EGS.) There are problems of comparability, but this level of poverty is probably well above the average figure for rural Maharashtra; the same poverty line applied to the 1977-78 Indian National Sample Survey gives a headcount index of 49 percent for rural Maharashtra (Kakwani and Subbarao 1990). A similar conclusion is suggested by a much smaller but more recent survey of 100 participating households in the EGS during 1985-86, reported in Acharya and Panwalkar (1988). The mean income of participating households was found to be about 20 percent below the poverty line. From this evidence, the EGS would appear to have performed well in reaching the poorest. Walker and Ryan (1990) and Bhende and others (1990) have studied the tar- geting performance of the EGS using household-level data over five years, 1979-83, for two Maharashtra villages. Their results suggest that the scheme is well targeted; days of participation on EGS decrease rapidly with increases in wealth, and participation is higher in the poorer of the two villages. The pro- gram effectively screens the poor, particularly in the richer village, where the potential losses from leakage are larger. Martin Ravallion 159 The FFWP data come from a 1982 household survey in the neighborhood of various project sites by the Bangladesh Institute of Development Studies (BIDS) and the International Food Policy Research Institute (IFPRI), as part of an eval- uation of the scheme (Ahmed and others 1985). The BIDS-IFPRI survey was comprehensive, covering thirty-one sites scattered over Bangladesh. When aug- mented with other recent data, this survey allows a more robust test of screen- ing performance. The test involves comparing the entire distribution of income among the BIDS-IFPRI sample of participants (before participation) with the distribution for rural areas as a whole, which can be estimated from independent sample surveys done by the Bangladesh Bureau of Statistics.4 Figure 1 gives the cumulative distributions of income from both surveys. We find that the scheme is quite effectively targeted toward the rural poor. For example, whereas 25 percent of rural households had an annual income per capita less than 1,500 taka in 1981-82, this was true of 60 percent of the house- holds with FFWP participants. Virtually all (96 percent) of FFWP participants in the sample had a household income per capita below 2,500 taka a year, for which 70 percent of the rural population would be deemed poor. But, no matter where one draws the poverty line, FFWP participants came from poorer house- holds than the rural population as a whole. Furthermore, it can be shown that a wide range of measures of poverty would improve (Ravallion 1990a). Days of employment are even better targeted toward the poorest of the poor than is participation; 70 percent of FFWP employment went to the 25 percent of rural households with an income per capita less than 1,500 taka (Ravallion 1990a). Forgone Income The surveys suggest that the schemes' performance in screening poor from nonpoor is good. The net income gains to participating households are more difficult to measure. Forgone income is the main cost involved (the monetary cost of transport to the site is probably negligible). This is likely to be highly seasonal and also to vary from year to year and across households. In a single- crop agricultural economy, the income forgone in the slack season is probably small. In casual discussions with a number of groups of EGS workers in the Pune district of Maharashtra during a slack agricultural season (May 1990), I raised the question, "If you did not have this EGS work, could you have ob- tained any other work?" Most answered that little or no work was available, but on further probing it became clear that many would have searched and, in time, found something. For example, some work was known to be available in digging and trucking sand for private contractors. The women were clearly more pessimistic about their prospects. Nonetheless, even in a slack season, it should not be assumed that forgone income is zero. What can we learn from the earlier surveys that might throw further light on the magnitude of forgone income? 160 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Figure 1. Income Distributionfor FFWP Participants and Rural Population as a Whole, Bangladesh, 1981-82 Cumulative percentage of households /_-~~ - ==-- 100 / 90 FFWP / 8 participants - 80 / / Rural Bangladesh 70 - 60 - 50 - 40 - 30 - 20 , 10 0 0 5 10 15 20 25 30 35 40 45 50 55 60 Household income per person (hundreds of taka a year) Note: FFWP is the Food for Work Programme. Source: Osmani and Chowdhury 1983, BBS 1986. Neither Dandekar and Sathe (1980) nor the further results in Dandekar (1983) reveal much about the extent of forgone income in their survey of EGS participants. The surveys by Acharya and Panwalkar (1988) give a better indi- cation. They studied two samples of 100 households each, one of which com- prised households with EGS participants spread over ten villages, whereas the other, although drawn from the same classes of landless and marginal farmers as the EGS households, covered ten villages where the scheme had not operated. Calculated from their reported results, the difference in mean income between the two samples represented 53 percent of the mean (gross) income from EGS participation. This suggests that average forgone income accounts for about half of the average wages received. However, this probably overestimates for- gone income, to the extent that the participant sample was self-selected dispro- portionately from among the poor. For the Bangladesh scheme, the BIDS-IFPRI survey indicates that the primary cost to participants arose from a shift from self-employment, both on and off the farm, rather than from wage labor. Still, the forgone income was not neg- ligible. A comparison of the incomes of FFWP participants with those of a Martin Ravallion 161 control group, adjusted for differences in their pre-FFWP incomes, indicates that the net income gain to participants was 57 percent of their gross earnings from the scheme (see Ravallion 1990a). Transfer Efficiency Cost-effectiveness in reaching the poor is also determined by the share of the wage bill in total costs. The wage bill for the EGS has typically represented 70 to 80 percent of the government's total outlays on the scheme, declining some- what over recent years to its present level of about 60 percent. Similarly, for Bangladesh's FFWP about 70 percent of the food aid used to finance the scheme was disbursed to participating workers (Ahmed and others 1985). From these various calculations on the two South Asian schemes, a crude assessment can be derived of the efficiency with which rural public works schemes transfer income directly to the poor. The available evidence on screen- ing performance warrants the assumption that virtually all participants are poor. The gross transfer to the poor is then the wage share of the scheme's cost, which I shall assume is in the range of 60 to 70 percent. According to the cal- culation for the EGS and Bangladesh's FFWP, the direct gain to participants net of forgone earnings is about 50 to 60 percent of the wages received. Thus the direct income gain to the poor under these conditions is 30 to 40 percent of the government's disbursement on the scheme. This is only a rough indication, and there is probably a wide variation around this figure in practice. In slack agri- cultural seasons and bad years, when forgone income is smaller, it would not be unreasonable to assume that at least half of the government's disbursement went directly to the poor. Other Benefits In assessing cost-effectiveness of the direct transfer benefit, one must also consider any indirect benefits (arising through the assets created or effects on markets) and risk benefits to the poor. Second-Round Effects Assessments differ as to how valuable the assets created by these schemes have been to the poor. Investment in basic rural infrastructure is widely thought to have a high economic rate of return in developing economies, through in- creased agricultural output (Antle 1983; Hazell, Khandker, and Singh 1989; Binswanger 1989; Binswanger, Khandker, and Rosenzweig 1989). The key is- sues are, jointly, the extent to which that return is realized by the infrastructure actually created by rural public works schemes whose prime objective is to alleviate poverty and the extent to which the poor have shared in those benefits. 162 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Material effects on output arising from the assets created by Bangladesh's FFWP have been observed (Ahmed and others 1985; Chowdhury and Asaduzzaman 1983; also see Ahmed and Hossain 1987), and sizable gains in output have been reportecl for the irrigation works created by the EGS (see PEO 1980). But other observers have been more pessimistic about the rate of return to food for work projects: see, for example, Reutlinger (1984) and World Bank (1986). The second-round effects on income arising from the assets created have clearly varied greatly. The principal problems for most projects appear to involve issues of policy design, particularly restrictions on nonlabor inputs. These issues are discussed later. Our main interest here is in the share of project outputs that has gone to the poor. A common criticism of the rural "public" works schemes in India is that the assets created have often been "privatized," with benefits going to the rural nonpoor without charge (Dandekar and Sathe 1980, PEO 1980). The enforce- ment of any form of cost recovery is notoriously difficult in this setting. The literature cited above and my recent discussions with EGS officials and benefiting farmers suggest that, provided care is taken in selecting and design- ing projects, it is feasible to generate economic benefits (by even distribution- ally neutral assessments) sufficient to cover short-run variable costs. Far less clear is how much the poor share in those benefits, either directly or through cost recovery. An optimistic view would be that benefits are uniformly distrib- uted so that the share going to the poor is simply proportionate to the popu- lation that is poor. Such a view would imply substantial indirect transfer benefits; for example, if 40 percent of the population deriving benefits from the scheme is poor, then the indirect transfer benefit would be as large as the direct transfer benefit roughly estimated in the preceding section. The effect of rural publlic works schemes on agricultural labor markets and tenancy contracts is an important but relatively unexplored issue. There have been studies of the general equilibrium effects of poverty alleviation schemes in this setting, but the models used have not included a labor market (see, for example, Parikh and Srinivasan 1989). The transfer benefits from a rural public works project include any effects on wages and other earnings from alternative activities. Time series evidence for India suggests that increases in the real agricultural wage rate generally reduce poverty (van de Walle 1985). Some sim- ple simulations for plausible assumptions on relevant parameters suggest that multiplier effects on incomes of the poor arising through labor market responses could easily double the direct transfer benefit (Ravallion 1987 and forthcoming). There is a pervasive impression that the principal schemes discussed have pushed agricultural wages up. Osmani and Chowdhury (1983) report this effect for the Bangladesh scheme, and it is widely believed that the EGS wage rate has influenced the agricultural wage rate in Maharashtra. The guarantee makes the EGS wage a credible threat in bargaining over agricultural wages. Indeed, an effective guarantee can enable enforcement of a minimum wage rate in Martin Ravallion 163 agriculture. However, if the wage rate is set too high, and work has to be rationed, then there may be little impact on agricultural wages. There is evi- dence that this has been happening on the EGS in recent years (Ravallion, Datt, and Chaudhuri 1990). It is sometimes argued that such schemes should not be allowed to compete with existing employment opportunities, because this distorts market alloca- tions. The economics of this argument needs to be looked at carefully. Avoiding new distortions to existing labor markets is imperative only if those markets (and, indeed, all other markets) were functioning efficiently before the policy intervention and if better policy instruments were available for achieving distributional objectives. Neither condition is plausible in this setting. A well- functioning public works scheme can make a positive contribution to both ef- ficiency and equity by reducing existing noncompetitive features in rural labor markets. Alternative income sources (such as public employment) can help break down the exploitative labor relations at the village level-discriminatory wage rate differentials, such as between men and women, between migrants and local workers, and across caste divisions-that arise from monopsonistic power of large landowners (PEO 1980, Dandekar 1983, Binswanger and others 1984, Subbarao 1989). Nor is the displacement of other employment sources necessarily a bad thing for the efficiency of transfers, since the transfer benefit to the poor depends on the gain in their earnings, not just their employment. The relevant economic comparison to make here is with the alternative forms of policy intervention, rather than the economy's first-best equilibrium. If labor market responses allow higher transfer benefits to the poor for the same social cost, this is a more efficient policy. Stabilization Benefits A misgiving frequently expressed is that a public scheme may displace exist- ing private and (nongovernmental) social insurance arrangements. The poor may find that family or community-based support at the village level declines after the introduction of rural public works providing employment in the lean season. To the extent that the existing risk-sharing arrangements work well, this would be worrying. But there are reasons tLo suspect that they do not. Casual observations suggest that savings by the poor are often insufficient to cope with even seemingly small deviations from normal seasonality or with more than one or two bad years in a row. The poor typically face restricted access to formal credit. Social insurance arrangements are thought to be im- portant in the traditional rural societies of South Asia and elsewhere (Platteau 1988, Ravallion and Dearden 1988, Cox and Jimenez 1990). These institutions are plausible outcomes of repeated interaction among households in risky en- vironments, but they can be expected to cope well only under certain circum- stances (Coate and Ravallion 1989). For example, if those involved discount future gains from reciprocity at sufficiently high rates, they will defect. 164 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Discount rates have been found to be high in dryland areas of rural India (Pender and Walker 1989), and they undoubtedly increase during hard times. Nor is there much scope for sharing risks that are highly correlated across households, as is common at the village level. The stabilization benefits of public employment schemes can thus be very important in risky agricultural settings. Rural public works have had a long and generally successful history as an instrument of seasonal stabilization and famine relief in India (see, for example, Jodha 1978; Lieberman 1985; Walker, Singh, and Asokan 1986; Dreze 1988; Dreze and Sen 1989). Walker and others (1986), for example, estimate that income streams in landless agricultural households in two villages where the EGS operated were 50 percent less variable (as measured by the coefficient of variation) than in a third village in an agro- climatically similar region where no such scheme existed. EGS employment peaks each year in the dry summer period (March to June), when there is little other employment, and declines rapidly afterward. Participation also fluctuates from year to year, depending in large part on the vagaries of the preceding year's monsoon. Recent data on EGS employment by month, based on unpub- lished records generously supplied by the Planning Department of the govern- Figure 2. Montbly Emplomnent on Mabarashtra's EGS, 1987-90 Person-days of EGS employment (hundreds of thousands) 200 - ,' '^ 1987-88 180 - , S 5 ,' ~~~~ts 140 " %A 120 1988-89 l 100 80/ 60 / 40 1989-0N 20- April May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. March Note: EGS is the Employment Guarantee Scheme. Source: Unpublished data supplied by the government of Maharashtra. Martin Ravallion 165 ment of Maharashtra, are given in figure 2. The higher participation of 1987 reflects the monsoon failure: as in the earlier drought of 1972-73 (Dreze forth- coming), the provision of public employment was crucial in the successful relief effort following the severe drought experienced in much of central and western India, including Maharashtra, in 1987 (Government of India 1989). From what we now know about the famine in Bangladesh during 1974, it is evident that if an effective rural public works scheme had existed, a great many people could have been saved from starvation and impoverishment (Ravallion 1987). The FFWP helped Bangladesh avoid famine in 1988, when condi- tions were not unlike those of 1974. Even in "normal" years, demand for Bangladesh's current works programs is quite seasonal, with probable stabili- zation benefits. Income stabilization through relief work can also bring long-term gains. The poor must often save in the form of cash or other suitably liquid assets to in- sure against down-side risk. The cropping decisions of marginal farmers are undoubtedly also influenced by uninsurable risks. It can be argued that produc- tive capital formation is constrained by the opportunities for insurance. If the poor know that extra employment will be availalble in lean seasons, or if mis- fortune strikes, they may be expected to save in more productive ways from their peak period incomes. The costs to the poor of certain coping mechanisms, such as indebtedness and distress sales of land, are also of concern. Extra income at a crucial time may well save a household from a far more cositly adjustment. For example, Cain and Lieberman (1983) find that, whereas the volume of land sales is highly correlated with the incidence of famines in a Bangladesh village, no such correlation exists in the Indian villages they studied. Access to relief work (including the EGS) appears to have allowed many of the poor in the Indian villages to avoid this very costly form of adjustment. Design and Financing Within the long-term budget constraint, a number of details of the design and financing of projects influence the scheme's cost-effectiveness in alleviating poverty. Design WAGE RATES AND COVERAGE. For a given long-term budget, the choice is be- tween a scheme that aims for wide coverage at potentially low wage rates and one that rations participation at a wage rate sufficient to allow more partici- pants to escape poverty. The choice depends in part on value judgments made in measuring poverty (Basu 1981). Elsewhere I have derived conditions for ranking stylized policy alternatives in terms of a broad class of poverty mea- 166 The World Bank Research Observer, vol. 6, no0.2 (July 1991) sures (Ravallion 1990b). When the severity of aggregate poverty is the primary concern, wide coverage at low wage rates appears preferable. This can hold even when the administrative cost per worker is quite high (although if that cost is very high, limitations on coverage become desirable). There are other arguments that support wide coverage. When eligibility for participation is universal--an aim of the EGS-the scheme provides effective in- surance against income poverty for all of those able to work. Provided the wage rate is set appropriately, seasonal rationing of work should be unnecessary. Wide coverage probably also reduces corruption by limiting managerial discre- tion in selecting beneficiaries. The case for wide coverage assumes that the policymaker can control the average wage rate on the scheme, so as to allow it to adjust to the long-term budget constraint. But in circumstances in which the wage rate is predeter- mined, employment cannot be guaranteed without losing control of the scheme's aggregate cost and so potentially violating budget constraints. The tradeoffs against poverty alleviation through economic growth may then be- come unfavorable. Such concerns have arisen about the substantially higher statutory minimum wage rates applied to Maharashtra's EGS since mid-1988 (World Bank 1989, Subbarao 1989). Good monsoons since then have helped keep participation and, hence, cost down. However, there are also signs that demand for work was unfulfilled after the wage increase; some of the poor gained but others lost (Ravallion, Datt, and Chaudhuri 1990). WAGE SCHEDULES. A notable feature of Maharashtra's EGS has been its success in attaining a rate of women's participation roughly equal to that of men. Sev- eral things have contributed to this outcome: sites are generally within easy reach of the village, and child care is provided (typically employing an elderly woman from among the participants). But an important factor has been that wage schedules are nondiscriminatory-piece rates for any given job are inde- pendent of gender (although differences in the type of work done can still lead to wage differentials). The choice between piece rates and time rates can also influence the scheme's performance. The use of piece rates can provide a powerful incentive for on- site efficiency. However, if time rates prevail elsewhere (and they are common in many lean-season agricultural operations) and are not sufficiently flexible, piece rates on rural public works may attract the more productive workers out of alternative activities, adding to the social opportunity cost of the scheme. And a piece rate system can yield very low wages to relatively unproductive but very needy persons. Some combination of time rates and piece rates may provide a better wage schedule. PROJECTS. The accessibility of project sites as well as wage rates will influence the scheme's performance. If local administrative capabilities are adequate and population densities are not too low, it should be feasible to provide Martin Ravallion 167 employment within walking distance of home for most of those in need. This has generally been the case for EGS projects-overnight camping is uncommon. However, there will be circumstances when it is not cost-effective (from the point of view of alleviating poverty) to insist on satisfying the demand for employment close to home. Administrative costs and the propensity of the poor to migrate should also be considered. The desire to help the poor directly has influenced other aspects of project selection and design. Projects and their production inputs have generally been chosen to maximize the employment of unskilled labor, often driving the quan- tities of other inputs (tools, raw materials, and so on) down to levels at which substitution possibilities with labor seem negligible. To ensure high labor in- tensity, policymakers have often restricted nonlabor inputs. For example, the EGS constraint that the cost of labor should account for at least 60 percent of the cost of variable inputs has often been binding in the selection of projects. Similar constraints (on the monetization of food aid) have been applied to Bangladesh's FFWP. Are such restrictions consistent with the objective of alleviating poverty? As already noted, it is the income gain to the poor, rather than the gain in partic- ipants' employment, that directly determines the scheme's effect on poverty. Ignoring risk benefits, the objective of alleviating poverty is served by maximiz- ing the transfer benefit to the poor, subject to the budget constraint; the trans- fer benefit comprises the increment to wage earnings of the poor plus the value of any benefits that the poor derive from the project's output, whereas the bud- get constraint equates net outlays on wages, materials, tools, and administra- tion to the scheme's revenue plus the share of benefits from the output accruing to third parties that can be recouped by the government (through, for example, user charges). Only under special conditions would the best combination of inputs for solv- ing this policy problem coincide with a conventional cost-minimizing alloca- tion. The distribution of benefits from the scheme would not matter to the latter, and so (under competitive conditions) inputs will be chosen in such a way that their marginal value product is equated with their prices. The optimal labor intensity for alleviating poverty will generally exceed the level that would obtain under conditions of perfect competition. Yet the argument for driving labor input up to its technologically feasible maximum is questionable. Optimal labor intensity depends on the ability of the scheme to attract only the poor, the benefits the poor can obtain from the scheme's output, and the extent to which income gains of the nonpoor from the project can be recouped. The case for simply maximizing the scheme's em- ployment, subject only to the technological constraint that at least something can be produced, rests heavily on an assumption that all benefits from the scheme's outputs accrue to the nonpoor, with the poor gaining nothing beyond the wages and the government being unable to capture any of the gains in out- put. Much of the direct wage benefit of these schemes does appear to go to the 168 The World Bank Research Observer, vol. 6, no. 2 (July 1991) poor and much of the nonwage benefit to the nonpoor, but it is hard to believe that this fully characterizes the possible outcomes, and that efforts cannot be made to increase nonwage benefits to the poor. Social returns to the assets created can also be enhanced by ensuring that projects are well integrated into existing rural development plans. Projects de- signed largely for immediate alleviation of poverty can often be coordinated with local and regional development plans. An example is Maharashtra's new scheme, Rural Development through Labour Force, an offshoot of the EGS that encourages local, village-level participation in formulating labor-intensive de- velopment plans, including specific EGS projects. Again, administrative capabil- ities may be the binding constraint in other applications. Financing Financing is necessary because much of the benefit to the nonpoor from ru- ral public works-such as increased crop yields from irrigation projects, or in- surance benefits-is difficult to recoup. In any case it is unreasonable to require a poverty alleviation scheme to cover its costs. Rural public works, like other public programs, can be financed either through changes in current taxes or expenditures or by borrowing; the method selected influences the success of a scheme. The same problems that make other forms of direct targeting a fairly blunt instrument for alleviating poverty also make it difficult to avoid having the poor bear some of the cost of financing. The poor may pay some of the direct cost of financing if, for instance, the scheme is funded through a tax increase, or they may suffer in the longer term through effects of the method of financing on growth. Cuts in other spending programs from which the poor benefit, or increases in relevant taxes, obviously diminish the gains to the poor. Nonetheless, the scheme can still be effective; for example, a public employment scheme that successfully reaches the poor can still reduce poverty even if partly financed by the poor, such as if other, less effective programs for alleviating poverty are cut (Ravallion forthcoming). Long-run effects on the poor of financing through borrowing are rightly of concern; excessive debt can have adverse effects on growth and (probably) the future alleviation of poverty. The creation of assets by these schemes ameliorates such effects: plainly, if the scheme can create as- sets with a rate of return similar to that obtainable elsewhere in the economy, the cost will be small (Parikh and Srinivasan 1989). The methods used to finance the EGS and FFWP do not seem to have encoun- tered the pitfalls just discussed. The $100 million cost of Maharashtra's EGS in a typical year has been financed largely by special taxes (income taxes on urban professionals, sales taxes, and a surcharge on irrigated land) and partly by gen- eral revenue. The immediate incidence of the cost of financing has probably been heaviest on the urban nonpoor (Abraham 1980, Herring and Edwards 1983). There is little obvious sign of adverse incentive effects in Maharashtra's Martin Ravallion 169 booming urban sectors. Bangladesh's FFWP has been financed largely from food aid; the poor have almost certainly borne some of that cost, akhough less than one might expect given that the main alternative channels for disbursing food aid in Bangladesh-under various food rationing schemes-appear to have largely benefited urban areas and not even gone proportionately to the urban poor (Abdulla and Murshid 1986 and an internal World Bank report). Divert- ing food aid out of the existing food subsidy schemes into the FFWP is likely to help alleviate poverty in Bangladesh. Conclusions The difficulty of designing cost-effective poverty alleviation policies when in- formation is highly imperfect may well be as daunting as the political con- straints on implementation. Means-tested transfers are rarely feasible in rural areas of developing countries. Experience with direct intervention suggests that corruption and other forms of leakage to the nonpoor can increase the cost of a given reduction in poverty now, thereby also climinishing the scope for alle- viating poverty in the future through growth. Sorne of the poor will simply not be reached, and leakage of benefits to the nonpoor is unavoidable. One way to reach the poor is to build incentives into the scheme that en- courage their participation and discourage that of the nonpoor. Work require- ments are an example. The wage rate that a worker will accept is likely to be positively correlated with income, so that a work requirement at an appropriate wage rate will screen the poor. Provided that forgone income, or other costs of participation, is not too high for the poor, self-selecting schemes based on work requirements are more cost-effective than alternatives. That is an empirical question. Evidence on the targeting performance of rural public works can be obtained from surveys of participants, but unfortunately past surveys have often focused on imperfect correlates of targeting performance, such as the proportion of direct benefits going to the rural landless. A better method is to ask whether participants were initially poorer than the population as a whole. Surveys that do allow us to focus on this question suggest that far more of the partic- ipating workers in both Maharashtra's Employment Guarantee Scheme and Bangladesh's Food for Work Programme came from low-income households than one would expect in a random drawing from the rural population as a whole. For example, my estimate for the Banglaclesh scheme is that 60 percent of participants come from the poorest quarter of rural households. Virtually all participants would be considered poor by conventional local norms. The literature affords surprisingly little evidence from which to measure the forgone incomes of participants. My estimates from past income surveys sug- gest that the immediate net income gain is about half of the gross wage pay- ment, although there are reasons to suspect that this may overstate forgone 170 The World Bank Research Observer, vol. 6, no. 2 (July 1991) income. The true figure is likely to vary substantially according to the season and the gender of the participant. Further research is needed to assess how much the seemingly excellent screening performance of such schemes is diluted by the costs of participation facing the poor. The indirect benefits are also hard to quantify. Even ignoring any benefits that the poor may derive from the assets created, the total benefit to the poor is probably larger than the direct transfer, once second-round effects on agri- cultural labor markets ancl tenancy contracts are taken into account. Some dis- placement of alternative employment is probably unavoidable and may be a positive part of the economic adjustments generating indirect transfers to the poor. Risk benefits can also be substantial in less developed agrarian settings. There is ample evidence from South Asia that relief work can save the rural poor from the potentially disastrous effects of a sudden contraction in real in- comes from other sources. This can save lives and can also prevent costly forms of adjustment, such as the sale of assets. The extra insurance provided may also encourage more productive investment. Rural public employment is not equally effective in alleviating poverty in all circumstances. Certain subgroups of the poor may be unwilling or unable to participate. Such subgroups, however, might often be identified by relatively nonmanipulable indicators, such as old age or physical disability, and so may be reached by other means (Dreze and Sen 1989). The combination of an em- ployment scheme and direct transfers to the unemployable often provides a comprehensive safety net for the rural poor. A relief work scheme should not be allowed to expand indefinitely. The scheme is likely to yield decreasing marginal benefits; the least poor tend to be the last to participate. And marginal costs to other objectives probably in- crease. An optimal size, then, will exist, and this could be reached well before income poverty is eliminated by the scheme. We should be wary of some of the rules of thumb that have been suggested to guide the design of these schemes. For example, once the full range of po- tential benefits is considered, the most cost-effective scheme is unlikely to be the one that simply minimizes the forgone income of participants, such as by employing only the unemployed. Nor is it likely to be the scheme with the best targeting performance, narrowly defined as the proportion of direct partici- pants who are poor. Maximizing employment of unskilled labor is also likely to provide a misleading guide to the selection of projects and their implemen- tation, in that it is not generally consistent with the maximum reduction in poverty for a given resource cost. One simple principle for policy design does seem to have a lot going for it: to aim for wide coverage at a wage rate consistent with the long-term budget. To target initial benefits to the poorest, to exploit the insurance benefits to all of the poor, and to undercut some of the possibilities for their exploitation on the project site and in labor markets, there should be as few restrictions Martin Ravallion 171 on eligibility as feasible, and wage schedules and the rights of participants should be well defined, well known, and nondiscriminatory. Ideally, all who want work at the going wage rate should be able to get it. The choice of that wage rate depends on the socially optimal budgetary allocation to the scheme, which should be determined by weighing the mrarginal benefits of alleviating present poverty against the marginal costs to other objectives of public policy, including the alleviation of expected future poverty. Notes Martin Ravallion is a senior economist in the Population and Human Resources Department of the World Bank. This article was written while he was in the Bank's Agriculture and Rural Development Department. He is grateful to Harold Alderman, Jock Anderson, Steven Coate, Gaurav Datt, Jean Dreze, Monika Huppi, Ravi Kanbur, Kalanidhi Subbarao, Dominique van de Walle, and Tom Walker for their helpful comments on the article. 1. I assume throughout that the goal of such policies is to raise the consumption levels of the poor by raising their incomes. This assumption is common, but not uncontested. The assump- tion ignores the preferences of the poor about leisure or, more generally, the allocation of time. For example, a previously idle person who takes up employment on rural public works may be only slightly better off in terms of utility (allowing for the loss of leisure), but much better off in terms of income. Here I am concerned only with the latter. 2. The working version of this article gives a diagrammatic demonstration of how a perfectly targeted scheme can be less cost-effective than an untargeted one (Ravallion 1990a). 3. Space limitations prohibit detailed discussion of policies other than rural public employ- ment. The working version of this paper surveys evidence on the main policy alternatives in South Asia (Ravallion 1990a). 4. See Osmani and Chowdhury (1983) and BBS (1986). There are problems of comparability, though they are likely to lead to underestimation of the scheme's targeting performance; see Ravallion (1990a) for a detailed discussion. 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Jour- nal of Development Economics 34: 57-80. 174 The World Bank Research Observer, vol. 6, no.2 (July 1991) - . Forthcoming. "Market Responses to Anti-Hunger Policies: Wages, Prices, and Employ- ment." In Jean Dreze and Amartya Sen, eds., The Political Economy of Hunger. Oxford: Oxford University Press. Ravallion, Martin, Gaurav Datt, and Shubham Chaudhuri. 1990. "Higher Wages for Relief Work Can Make Many of the Poor Worse Off. Recent Evidence from Maharashtra's 'Employment Guarantee Scheme."' PRE Working Paper 568. World Bank, Agriculture and Rural Develop- ment Department, Washington, D.C. Processed. Ravallion, Martin, and Lorraine Dearden. 1988. "Social Security in a 'Moral Economy': An Empirical Analysis for Java." Review of Economics and Statistics 70 (February): 36-44. Reutlinger, Shlomo. 1984. "Project Food Aid and Equitable Growth: Income-Transfer Efficiency First!" World Development 12: 901-11. Roberts, Kevin. 1984. "The Theoretical Limits to Redistribution." 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Economic and Political Weekly 21 (June): A81-A88. World Bank. 1986. Poverty and Hunger: Issues and Options for Food Security in Developing Countries. Washington, D.C. . 1989. India: Poverty, Employment, and Social Services. A World Bank Country Study. Washington, D.C. . 1990. World Development Report 1990. New York: Oxford University Press. Martin Ravallion 175 o CASH FLOW OR INCOME? The Choice of Base for Company Taxation Jack M. Mintz Jestis Seade Cash flow and equity incorne (or income) are two alternative bases advocated for taxes on businesses throughout the world. Although in practice most tax systems are hybrids with elements of both types of taxes, recent literature has stressed the merits of the cash flow tax because it is simple in concept and it does not distort decisions about capital expenditures and financing. But inter- national issues and administrative complexities-particularly tax evasion- present problems that must be sorted out before a cash flow tax can be imple- mented. T- j !!he standard tax base for companies is corporate income: revenues from the sale of goods and services plus financial income, minus wages, depreciation, inventory costs, and interest (adjusted for inflation). In re- cent years, however, tax theorists and practitioners have expressed considerable interest in the use of cash flow as the tax base. The concept is simple: the tax base is the difference between the receipts from the sale of goods and services and the current and capital expenditures of the enterprise over a given period. If cash flow is used as the base, there is no need to calculate the tricky numbers that lie at the core of the standard tax on company income or to engage in complex accounting exercises to depreciate assets or correct for inflation. Only cash flow matters-real transactions, or transactions plus financial flows, de- pending on the definition adopted. No country has so far introduced the tax, except in isolated sectors of the economy. The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 177-190 0 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 177 Much of the early literature (see, for instance, Brown 1948, who introduced the topic of the cash flow tax; Smith 1963) concentrated on the differing effects of cash flow as opposed to income taxes on incentives for investment and fi- nance. It was not until the 1970s that the Meade report (Institute for Fiscal Studies 1978) and Blueprints for Basic Tax Reform (U.S. Treasury 1984) attempted a comparison of the relative economic merits of the two methods, especially with respect to efficiency, equity, ancl simplicity. But these and sub- sequent reports (Bradford 1986; Boadway, Bruce, and Mintz 1987; and King 1987) were written in the context of industrial countries and did not deal with the administrative, international, and transitional issues relevant to developing countries. Although most countries use income as the tax base, in practice the fiscal definition of income rarely resembles the true equity income earned by the shareholders. For example, nominal interest is almost always deductible from the tax base, even though only the real (adjusted for inflation) component should be deductible. It is also interesting to note that since it is not easy to measure equity income accurately, cash flow methods (for instance, allowing deductions for research and development) are often used. Also, many tax sys- tems in developing countries provide substantial tax incentives for capital. These tax systems are thus only nominally income-based. They are based nei- ther on income nor on cash flow; instead, they are some sort of hybrid, often incorporating substantial tax writeoffs that subsidize the use of capital at the margin. The incentives include such deductions as accelerated depreciation, investment tax credits or allowances, and even tax holidays. These hybrid sys- tems are more generous in their treatment of capital than are pure cash flow taxes since interest is deductible and capital is expensed (that is, capital expen- ditures are allowed as an expense in the calculation of tax liability). This double deduction for capital outlays encourages the use of capital and may mean that countries lose a great deal of revenue. In the face of these complex and hybrid systems, many developing countries have adopted reforms to broaden the tax base and lower statutory tax rates. But while a central objective of tax reform has been to establish a duly defined income base, administrative limitations have been more serious than expected in some cases, and in others governments have lacked the political will to im- plement a serious and comprehensive tax reform. Policymakers in many coun- tries are convinced that designing an income-based tax system that incorporates adjustments for inflation is too complicated, so they have concen- trated instead on making sure that taxable business income reflects the book profit earned by the firm. It is precisely because income taxes are difficult to implement-quite apart from their distortionary effect on investment and financing decisions-that some economists argue for the cash flow tax. Developing countries meanwhile contend that since business taxes are credited against the corporate tax bill in the company's parent country, the cash flow tax may simply transfer tax reve- 178 The World Bank Research Observer, vol. 6, no. 2 (July 1991) nues abroad. More important, policymakers fear that it would be difficult to implement a cash flow tax, and they are understandably reluctant to adopt a tax that has been neither tried in any meaningful way nor sufficiently well thought out for practical imaplementation. This article evaluates the relative merits of cash flow and income as bases for company taxation. The principal concern is implementation: the appropri- ateness of a company tax ultimately depends on feasibility, even though other issues, such as economic efficiency, will play a role. What follows is an inven- tory of the practical problems of applying a cash flow tax compared to an in- come tax in developing countries. We start, however, with a brief review of the economic issues. The Role of Corporate Taxes Why should companies, which are merely legal institutions, be taxed at all? Why not tax the individuals who own the company? In other words, what is the economic role of the company tax? The choice of an appropriate tax base depends on the answer to this question. It may also depend on the relation between corporate tax rates and personal tax rates. A corporate tax can serve three economic functions. The Withholding Role The corporate tax serves as a withholding device on income that may be difficult to tax at the personal level. If it is desirable to levy an income tax on all forms of income, then capital gains (adjusted for inflation) should be taxed annually on an accrual basis. But it is difficult to tax accrued capital gains at the personal level because of the complexity of valuing nonmarketed assets and the problems for liquidity-constrained investors of paying taxes on an accrual basis.' A corporate income tax prevents individuals from deferring tax pay- ments by leaving profits in the company rather than distributing them as divi- dends or interest. And it avoids the complications of assessing individual holdings in the company. A second argument for using the corporate tax as a form of withholding arises when the personal income tax is consumption-based (or lifetime income-based). In this system the tax base is equal to labor earnings plus inheritances and claims on the economic rent earned by companies. Savings are exempt from taxes, and assets are treated in one of two ways: savings in designated assets are deducted from the tax base and the withdrawals from these assets are taxed (this is called the registered asset method), or interest on assets is tax exempt (the nonregistered asset method). With nonregistered assets, taxes on economic rent and labor income, unless withheld at the source, can be avoided by paying out income in dividends or in other forms of Jack M. Mintz and Jesas Seade 179 capital income that escape taxation. Thus if a lifetime income tax is desired, a cash flow tax on companies can be used to tax economic rent and nonwage labor income. A third argument for establishing a corporate tax is that the tax revenues in question could otherwise accrue to foreign investors and their parent govern- ments, leaving little income in the host country. Taxing Economic Rent The most efficient tax-that is, one that entails the least reduction in welfare for a given amount of revenue raised-is one that applies to economic rent. Economic rent from an activity is the excess of payment over the compensation required for the activity to be undertaken. If such a surplus exists, taxing it would not distort decisions about production and investment at the margin, since the compensation required for the activity is already accounted for. For a company, economic rent is the surplus of revenues over wages, interest expenses, and the imputed cost of equity financing. (Note that this amount is less than the accounting profits of the company since the latter do not include a deduction for the imputed cost of equity financing.) When economic rent is taxed, decisions about investment and financing' are unaffected since the firm can deduct the true opportunity cost of capital and labor from its tax base. The cash flow tax, therefore, operates as a simple tax on economic rent, since allowing firms to write off capital expenditures is equivalent, in present value, to a deduction of the true depreciation and financing costs. (The cost of risk is implicitly deductible too, as long as tax losses are fully deductible or refundable.) Economic rent is the return to fixed factors of production (that is, those whose use cannot be changed in response to economic circumstances). Some of these factors may in fact be supplied by the government, and the company tax can therefore be seen as a legitimate price for these services. The govern- ment could extract these payments by auctioning off rights (for the use of public property or of government-owned nonrenewable resources, for example). The cash flow tax is an alternative that serves as a proxy for such payments. Economic Policy Another perspective on the company tax is obtained by considering the gen- eral problem of raising revenue at minimum efficiency cost, particularly when it is administratively difficult to tax certain commodities or activities. Leisure is a prime example. In this case, it may be efficient to tax commodities or activities that are complementary to those that cannot be taxed. If current saving and accumulation are complementary with leisure in later years (perhaps in the form of early retirement), an argument can be made for taxing 180 The World Bank Research Observer, vol. 6, no. 2 (July 1991) companies, to the extent that individuals accumulate wealth in the form of cap- ital gains on investments. Of course, other taxes may also be used to tax com- modities or activities complementary to leisure (such as second homes or pleasure travel). Other activities may be untaxed as well, depending on the ex- tent of integration of the economy, the size and nature of informal markets, and the state of tax administration. For some of these, there may be additional arguments for taxing companies. In addition, a company tax can be used to offset the effect of market fail- ures. For example, there are some activities, say pollution, that the government wants to discourage and there are others, such as research and development, that it wants to encourage. Fast writeoffs, investment tax credits, and rate reductions are used to encourage investment in particular assets and industries. In principle, tax incentives play a role. They are, however, so difficult to apply that other policy tools, such as grants, may be preferable. Tax incentives make tax laws more complicated and, unlike grants, make it difficult to mon- itor the response of investment in the sector affected. In their favor, tax incen- tives are more easily put in place than are grant programs, since firms do not need to apply for the benefits. Integrating Company and Personal Taxes Since company income eventually accrues to individuals, differences in the company and personal tax systems can distort market decisions. Moreover, these differences allow for tax arbitrage, as different kinds of income or costs are shuffled for maximum tax benefit rather than for maximum economic re- turn. To overcome these efiects, the two tax systems should be as closely inte- grated as possible. Is the choice of tax influenced by these considerations? It is often argued, for example, that a cash flow tax can operate only in conjunction with a per- sonal consumption tax. It is not true, however, that the tax bases must be anal- ogous from the outset: appropriate crediting arrangements, whereby taxes paid at the company level are reimbursed once the income is paid out to individuals, can accomplish the same thing. It is possible to levy an income-based tax on companies with a personal con- sumption tax on individuals by, for example, allowing a dividend tax credit for the taxes paid by the company. In a closed economy such integration can be achieved easily. In an open economy, however, the tax credit makes company taxation less attractive, since tax on the income of foreign owners, which would otherwise be withheld, is captured by the foreign government. If, how- ever, the tax credit is restricted to domestic shareholders, it may only subsidize savings without affecting decisions about production and investment, particu- larly in the case of companies that can finance capital from domestic and international sources.2 Jack M. Mintz and Jesas Seade 181 Similarly, a cash flow tax can operate along with the standard personal in- come tax system. Suppose all capital income is taxed at the personal level. Governments can now tax the economic rent earned by companies through a cash flow tax, without integrating the tax with the personal income tax. Some- thing will have been lost relative to the case in which companies are taxed on cash flow and individuals on consumption, but if a consumption-based personal tax is not feasible, this is the next best alternative. Thus integration itself should not be an insurmountable obstacle to reform. Much can be achieved through appropriate changes to existing personal tax systems. This is not, however, to minimize the benefits of integration. As noted earlier, lack of integration can lead to economic inefficiency and can aggravate many problems of implementation, such as compliance, the observability of the tax base, and the treatment of tax losses. Implementation In implementing a company tax, officials must consider two administrative issues: first, the observability of the tax base and second, the complementary problems of tax evasion and tax avoidance. The Observability of the Tax Base The measurement of the tax base by the firm and by the tax authorities is more difficult under an equity income tax than under a cash flow tax for the following reasons: X The concept of income requires revenues and current costs to be reported on an accrual-rather than a cash-basis. This creates a problem in the determination of tax liabilities when income is generated after input costs have been deducted, for instance, in construction projects, discoveries of natural resources, and capital gains on property. * Capital gains create a particular problem. In principle, accrued capital gains (or losses) should be taxed (or deducted), but these calculations can be monitored in only a few cases, and then only imperfectly (through adjustments in the provisions for depreciation). Even the use of realized capital gains, already a substitute, is subject to problems of measurement. * Depreciation (valued at replacement costs after deducting real capital gains) is difficult to measure, especially in countries that have thin second- ary markets for capital. * The treatment of inventory inputs or outputs is a continuing problem. Filers must resort to simple ad hoc rules to allocate the true economic cost. * In principle, a good equity income base requires adjusting interest deduc- tions for inflation. Filers must report not only interest costs but also the 182 The World Bank Research Observer, vol. 6, no. 2 (July 199t) value and composition of debt liabilities. This can be a difficult task that requires detailed accounting. * It is impossible to measure depreciation on such assets as research and de- velopment, advertising, depletable assets, and other capital expenditures. These items are thus expensed on a current basis in most tax systems. With a cash flow tax, all these problems essentially disappear. The use of sales minus purchases (or variants that incorporate financial flows) eliminates any role for the concept of economic costing, thus ridding the tax administra- tion of the need to deal with questions pertaining to the timing of benefits, inventory, depreciation, and capital gains. Capital gains and depreciation in particular virtually disappear as legal concepts and headaches as all purchases are simply deducted in full when made and no record of the transaction is nec- essary. Any subsequent capital divestiture is then treated as taxable revenue. Inflation adjustment also becomes unnecessary, since there is no need to take deductions on interest. New problems do, however, arise. The immediate deduction for plant and equipment, although technically desirable and similar to any other business ex- pense, can give rise to tax evasion and yields an exceedingly lumpy profile of tax obligations. In these cases the government may need to adopt special provisions to avoid abrupt increases in a firm's tax liabilities. Taxation of fi- nancial institutions is difficult as well because most revenues and outlays are financial flows to which the tax may not apply (for administrative reasons), and the costs of equipment and materials technically create a negative cash flow. Since no country has so far implemented the tax, lack of precedent and experience makes it difficult to predict other administrative difficulties. Thus it is not clear whether a cash flow tax is superior to an income tax from the point of view of tax administration. The cash flow tax is preferable in that the definition of the tax base for most of the productive sectors is straightforward-a useful consideration in developing countries, where accounting and administrative capabilities are typically modest. But there are serious problems in the treatment of certain major sectors and in the interface with the individual income tax. It is not clear which system has the advantage. But tax policy goes beyond the demands of accounting. Another consideration is whether the tax system is subject to abuse if it should become easier to con- ceal income. Avoidance and Evasion Tax avoidance and tax evasion arise in two situations. First, the difficulties noted earlier in measuring and monitoring the tax base enable taxpayers to un- derstate their incomes. Second, some activities cannot be or simply are not- taxed. A considerable amount of legal tax avoidance takes place this way, as resources flow toward these opportunities. These gaps also generate outright Jack M. Mintz and Jesus Seade 183 evasion through the use of such mechanisms as transfer pricing, by which the firm arranges to take high profits in a low-tax area, or leakage, by which a firm can shift income to activities that are favored, such as exports, rather than claim it under domestic sales, which are taxable. "Tax losses" are another important mechanism for avoidance and evasion. When the company's operations record a loss, the tax treatment of these losses raises important economic issues. It is argued that such losses should at- tract a tax credit or refund. In this manner the refundability of the tax is an implicit deduction for risk; the government shares the firm's losses and gains. Refundability is generally accomplished by allovving the firm to carry forward losses (at a specified interest rate) to offset its tax liability when times are better. If the firm is liquidated it is entitled to any tax credit owed to it. The tax treatment of losses is not a serious issue, provided different sectors and activities are taxed evenly across the economy. The problem arises when income can be shifted from taxable to tax-exempt or other favored activities. For example, suppose a firm writes off a capital investment as an expense, sus- tains a loss, and receives a tax credit. If the firm can shift income to nontaxable companies, such as pension funds, the tax credit essentially subsidizes the acquisition of capital. Transferring losses to an entity that has positive tax li- ability is only one example of the ways firms use loss provisions to minimize taxes. Given loss offset provisions and the uneven tax treatment of companies, which tax is better? A loss is more likely using the cash flow base, because current and capital expenses will typically exceed revenues while the company is growing and investing. Although the effect can be mitigated by alternative provisions (such as including financial transactions in the calculation of cash flow or allowing depreciation rather than deduction of capital costs), important losses will occur in the early years of an investment. This suggests that the cash flow tax may make avoidance easier. Evasion may also be easier because reve- nues from the cash flow tax are less constant than are those from the income tax because of the lumpiness of investment outlays. Furthermore, the uneven- ness of revenues from the cash flow tax makes increased arbitraging more like- ly. For example, a company that has no tax liability because of a large investment outlay can collude with an affiliate to boost its (nontaxable) reve- nues through transfer pricing. Similarly, a firm could build up tax credits by taking advantage of loss provisions (and other tax breaks) after an investment and then dissolve and sell to a tax-exempt firm at the point where cash flow becomes positive. The value at which assets are sold is much harder to police than are the operational accounts. One could, however, overemphasize the potential for tax evasion. Evasion is equally possible under income tax through the reporting of capital gains and interest, the timing of asset sales and inventories, and the treatment of com- pensation to workers. 184 The World Bank Research Observer, vol. 6, no. 2 (July 1991) International Policies International tax policies affect the decision for two reasons. First, capital- especially new capital-is quite mobile and will find its way to the most hos- pitable investment. And second, the firm's income is also mobile. Corporations shift profits from one country to another by rearranging financial assets and liabilities without moving real resources. And, by taking advantage of differ- ences in tax regimes across countries, multinational corporations minimize their payment of corporate taxes on worldwide profits by taking deductions in high-tax countries and reporting income where tax rates are low. This avoid- ance is partly controlled through international tax treaties. Countries compete not only for capital but also for tax revenues. For the purposes of this article, we are concerned about two questions. First, which tax is best: an income tax that retains tax revenues from financial outflows and remittances, a cash flow tax that may be more effective in attracting the mar- ginal foreign investor, or some other tax or combination of these? Second, to what extent can a country follow an independent tax policy? Must countries adopt by law-or accept in practice-essentially uniform tax policies? If a country pursues a different tax system, what provisions must be adopted to en- sure that the tax is implemented properly? The answers to these questions depend on the nature of capital markets and the size of the country. A large country can influence interest rates on interna- tional securities to its advantage and can use tax policy to this purpose by altering international capital flows. For example, if the country is a capital im- porter, a tax on investment that lowers the international demand for capital forces down interest rates. But most developing countries are small players in the international capital market, and it is unlikely that they can influence international interest rates or product prices. A corporate tax in developing countries alters the margin of decision for foreign investors, and the govern- ment has to balance its revenue needs against the possible distortionary effects on foreign investment in the country. TAXING COMPANIES IN AN OPEN ECONOMY. Tax policy in an open economy must address the respective taxes on the income of foreign companies and on the income earned abroad by domestic corporations. Here we concentrate on the former, which is more important for developing countries. The effects of a tax on the income of a foreign company depend on how the company's income is treated in the parent country. If the parent country exempts the income earned abroad, a cash flow tax base is preferable because an income tax will distort choices at the margin and will give the host country less investment for given revenues raised. There are cases, however, in which the parent country does not exempt the income earned abroad but does allow the firm to take a tax credit. In this case, the criterion for evaluation is again which tax will provide more investment for Jack M. Mintz and Jesas Seade 185 given revenue or, equivalently, more revenue for given investment. Under such circumstances a tax on repatriated income is preferable, since the company's tax credit leaves it free to invest regardless of the host country's tax regime, and the cash flow tax would open up a margin of distortion between the tax paid in the host country and the credit it received in the parent country. In practice these tax arrangements are quite complex. For example, Japan, the United Kingdom, and the United States all grant credits for foreign taxes on repatriated income-dividends, interest, and royalties. When income re- tained abroad by a subsidiary is exempt from taxes in the parent country, the host country should levy an income tax on repatriated earnings but should tax retained profits in terms of cash flow. The administrative complexities of such arrangements are clear, but the point is that the choice depends on the tax structure in the rest of the world. Currently, income taxes in host countries qualify for tax credits, but would a cash flow tax qualify? UNIFORM TAX STRUCTURES. Reforms in the company tax have been remark- ably similar across countries. Most countries have lowered corporate tax rates and broadened the tax base by reducing tax incentives. The rationale is that countries are forced to follow the tax reforms adopted by others to preserve the tax base. But given the multidimensional nature of tax policy and the many other relevant instruments at hand, is it impossible for a country to pursue an independent tax policy? It is argued that if there are differences in tax systems, capital will flow to the least taxed country. This argument is largely unconvincing. It is truer, if anything, as a statement about the level of taxation than about the structure. Although political pressure might persuade developing countries to levy the same tax used in foreign jurisdictions, there is no clear economic justification for this decision. Even if capital is relatively mobile, tax regimes could differ depending on the structure, the use of tax revenues, and the reliance on other tax instruments. If, for example, a country imposes high tax rates and offers many incentives, internationally mobile capital will avoid investing in taxed sectors. But the country may attract resources in the sectors it wishes to pro- mote. Similarly, leaving aside the issue of crediting, a small open economy might find it in its interest to levy a cash flow tax despite the decision by other countries to impose distortionary capital taxes. Moreover, if the company tax is an important source of revenue, a country might levy a higher capital tax to finance public expenditures. Although tax regimes might affect each other, uni- form taxes are not necessarily a foregone conclusion. The competition for tax revenues is a better argument for some degree of uniformity. The usual justification for uniform tax bases is that tax arbitraging gives multinational corporations an advantage over domestic firms. Transfer pricing, financing and leasing arrangements, and other tax planning devices can create serious problems. One argument against the cash flow tax or indexed income tax is precisely that no other trading partner has a similar tax. 186 The World Bank Research Observer, vol. 6, no. 2 (July 1991) If a country tries to implement a cash flow tax or an income tax with fast writeoffs and higher rates than other countries, several issues arise. First, such costs as overhead that can be quickly deducted or depreciated tend to be allo- cated to the country that provides the most generous incentive. It is also pos- sible for the firm operating in a jurisdiction with a cash flow tax to lease capital to a parent or subsidiary in other countries, especially when those countries offer less favorable incentives to capital. Thus the cash flow tax could discour- age investment. Second, if interest deductions are limited to the real interest rate-or not allowed at all-a company could issue debt in countries that allow nominal interest to be deducted. If a number of intercorporate transactions are made to avoid further taxation, the debt could then be used to finance the acquisition of capital that uses the cash flow tax or the indexed income tax. This gives an advantage to large companies that have better access to international capital markets. The country that imposes the indexed income tax or cash flow tax, however, would find that multinational companies were financed more with equity than with debt, which leads to higher corporate tax revenues. Third, if the tax rate is higher than other jurisdictions, there will be an in- centive for multinational companies to underprice goods for export, particular- ly if the goods are sold to associated companies abroad. Interest, royalties, and lease payments on transactions between the parent and the subsidiary could also allow firms to shift profits to low-tax countries. These possibilities for arbitrage also depend on how foreign-earned income is taxed. For example, transfer pricing may not work if foreign taxes are fully credited by the parent country and the corporation cannot exploit the differ- ence in tax rates. The importance of these issues depends on the ability to de- vise tax systems that avoid eroding or distorting the tax base. Transition between Tax Regimes Transition from one tax regime to another raises two problems: windfall gains (or losses) and the effect on efficiency (that is, the tax system should not distort the allocation of resources in the economy). Avoiding any windfall gains or losses as a result of the imposition of a new company tax base is essential. Moreover, since business decisions are based on the tax system existing at the time, a retroactive change is destabilizing and runs the risk of eroding the cred- ibility of the tax policy. In addition, tax policies that create windfall gains (or losses) for the public may be quite inefficient (or efficient). For example, if the government limits interest dLeductions to a real basis, with an indexed corporate income tax, or eliminates interest deductions, with a cash flow tax, firms that are leveraged will find their taxes are substantially higher because they had expected to continue to deduct the full nominal interest. The increase in tax is a one-time windfall loss to the company's shareholders. From the point of view Jack M. Mintz and Jests Seade 187 of the government, the additional tax revenue is economically efficient because the tax is raised without affecting the company's decisions. The effect of implementing a new company tax system depends not only on the old tax but also on the desired treatment oiF old assets under the new re- gime. Old assets can be either exempted from tax changes or treated on the same basis as new assets. If old assets are exempted, they may increase in value if new assets are subject to a higher tax (or vice versa); if old assets are treated on the same basis as new assets, the old assets may be subject to a tax different from the one applied to new assets. Transitional arrangements have an important effect on the amount of tax paid by the corporate sector. If a company income tax is replaced by a cash flow tax, the whole depreciable stock and outstanding debt of the corporate sector must be moved across fiscal regimes. One way to arrange the transition is simply to exempt old assets from the cash flow tax and retain the former treatment of old debt. This requires depreciating old assets on the same basis as before, which is not a major problem. It also requires retaining the deduct- ibility of interest payments on the outstanding debt-but not on new debt. Of course the need to keep track of the different vintages of debt incurred by the firm allows unbounded manipulation by any creative tax accountant. The simplest solution would be to permit firms to deduct all the remaining depreciation on old assets but to prohibit deductions on interest. The problem is that the time profile of deductions and debt repayment on any one investment is not the same. The gain on the one side may exceed or fall short of the loss on the other (from nondeductible interest). Some firms will face bankruptcy and others will claim inequities. Officials will have to compromise and impro- vise. Other methods might perform better economically or administratively, but there is no known painless solution. The effect on tax revenues of a shift from income taxes to cash flow taxes depends on what happens during transition and on the existing income tax pro- visions. A cash flow tax that applies to new and existing assets could yield sub- stantial tax revenues because old assets would no longer be granted depreciation and interest writeoffs and would be fully taxed if sold to other firms. If, how- ever, the government exempts old assets, tax revenues could fall. In developing countries that offer substantial writeoffs for capital (for instance, Bangladesh and Malaysia) or offer tax holidays (Morocco and Thailand), eliminating the deductions for interest under the cash flow tax could raise substantial revenues. In other countries revenue could be lost, especially if the corporate tax has served as a rent-collecting device, with few fast writeoffs or tax holidays. Conclusion In implementing either an indexed income tax or a cash flow tax on busi- nesses, officials must consider several variables, some of which have been 188 The World Bank Research Observer, vol. 6, no. 2 (July 1991) addressed in this article. The matters of efficiency and distribution, commonly discussed in the literature, are only two areas of concern. Further investigation, particularly of issues of administration and international compatibility, is required. Some assert that officials should first determine the type of tax base and then worry about administrative issues. The motive for adopting a company tax de- pends in part on the type of individual income tax desired and on the degree to which a country may wish to withhold income from foreign firms. But the problem is whether a particular tax base can be effectively implemented if ad- ministration is weak and there are international complications. In a closed economy, especially one that relies on a consumption tax at the personal level, the cash flow tax seems to be a simple and efficient corporate tax. It is relatively straightforward to administer and is neutral with respect to investment decisions. The iincome tax, in contrast, is inherently more compli- cated and has little to recommend it, apart from the fact that it is slightly more difficult to evade. A more fundamental problem, however, is that lack of experience with the tax means that it is impossible to predict what administrative and operational difficulties would occur. A great deal of preparation preceded the introduction of the value added tax in a few countries several decades ago, and other coun- tries only seriously considered adopting it after a fair amount of experience was available. If uncertainty is a cost in economic decisions, this factor must rep- resent a sizable minus from the point of view of the cash flow tax in the developing world. Another problem is the way the tax fits the international economy. In this context, a case can be made for a tax on income. If the country has a large foreign-owned sector, the income tax may be the best way to withhold income from foreigners. The tax is credited against foreign taxes and so, in certain circumstances, has little effect on investment. Income taxes are used in other countries, minimizing the possibility of tax arbitrage. The income tax, however, is-or becomes more-distortionary to the extent that it is not cred- ited abroad. And sometimes, as in the case of petroleum and mining royalties that serve as taxes on rent, the income is not credited against foreign taxes. This could make the case for a cash flow tax more persuasive. If there is no crediting, the cash flow tax has the virtue of being neutral, while still withhold- ing rents accruing to foreigners. In contrast, a value added tax is paid only by residents of the country. To this extent a countervailing argument can be made for a cash flow tax in an open economy as well. We have argued that no pure case can be made for either cash flow taxes or income taxes. While cash flow taxes are clearly simpler in design, their admin- istration is clouded by international issues. For developing countries that rely on company income taxes that already include fast writeoffs for capital, the cash flow tax may be attractive in eliminating generous deductions for capital. Jack M. Mintz and Jesus Seade 189 How the cash flow tax would work in an international environment, however, is a question that requires more analysis. Notes Jack M. Mintz is the Arthur Andersen Professor of Taxation at the University of Toronto. Jesus Seade, Mexico's ambassador to the General Agreement on Tariffs and Trade, was principal economist in the World Bank's Brazil Department when this article was written. 1. Auerbach (1988) suggests some possible schemes for assessing taxes on capital gains at the time of sale that would be accrual-equivalent by taking into account the value to the investor of postponing realized capital gains taxes by holding assets longer. 2. Computing the base for inflation is complicated under income taxes; it is not an issue under cash flow taxes because they always measure costs and revenues in dollars contemporary to the tax due. Although the cash flow base does not have to be indexed for inflation, it is necessary to index tax obligations, especially in countries with high rates of inflation, because the lag in paying the tax will reduce the real value of the payment. References The word "processed" describes informally reproduced works that may not be commonly available through libraries. Auerbach, Alan J. 1988. "Accrual Equivalent Capital Gains Taxation." University of Pennsylvania, Philadelphia. Processed. Boadway, Robin W, Neil Bruce, and Jack M. Mintz. 1987. Taxes on Capital Income in Canada: Analysis and Policy. Toronto: Canadian Tax Foundation. Bradford, David. 1986. Untangling the Income Tax. Cambridge, Mass.: Harvard University Press. Brown, E. Cary. 1948. "Business Income Taxation and Investment Incentives." In Lloyd A. Metzler and others, eds., Income, Employment and Public Policy: Essays in Honor of Alvin H. Hansen. New York: Norton. Institute for Fiscal Studies. 1978. The Structure and Reform of Direct Taxation. Report of a committee chaired by Professor James E. Meade. London: Allen and Unwin. King, Mervyn A. 1987. "The Cash Flow Corporate Income Tax." In Martin S. Feldstein, ed., The Effects of Taxation on Capital Accumulation. Chicago: University of Chicago Press. Smith, Vernon L. 1963. "Tax Depreciation Policy and Investment Theory." International Eco- nomic Review 4 (January): 80-91. U.S. Treasury Department, Tax Policy Staff. 1984. Blueprints for Basic Tax Reform. 2d rev. ed. (lst ed. 1977). Arlington, Va.: Tax Analysts. 190 The World Bank Research Observer, vol. 6, no.2 (July 1991) THE MARKET FOR DEVELOPING COUNTRY DEBT The Nature and Importance of Its Shortcomings John Wakeman-Linn There are two problems in the market for developing country debt: one is the immediate crisis. What do we do about the large volume of outstanding debt? A more subtle but no less important problem is that because contracts are un- enforceable and lenders have incomplete information about risk, capital is mis- allocated. This article examines the latter problem and reviews the nature and causes of the unenforceability. It shows that unenforceability results in higher interest rates on smaller and shorter-term loans than would otherwise be avail- able and discourages investment in developing countries. Similarly, unenforce- ability can explain the perverse timing of capital flows to developing countries, causing credit to flow into the country when income is high, and out when income is low. The article then analyzes the risk associated with three types of information asymmetries. information about the borrowers' ability to repay, willingness to repay, and use of the loan proceeds. These asymmetries, the author argues, reinforce the effects of unenforceability. The prospects for remedying the immediate crisis are discussed, as is the need to be certain that the proposed solutions do not aggravate these problems. G overnments regularly intervene in credit markets in an attempt to rec- tify market failures. The U.S. government, for example, guarantees loans for students on the assumption that the market will provide too little credit for investment in human capital. TheTFarm Credit System was es- tablished because of a perception that the market was providing too little credit The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 191-203 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 191 for agricultural producers (Webb 1980), and domestic fiscal policy encourages credit in home mortgage markets in an effort to capitalize on the social benefits of homeownership. In one important credit market, however-the market for developing country debt-there has been no government intervention. This restraint exists not because this market suffers from no shortcomings; indeed, its shortcomings dwarf those in the mortgage market, for example. The lack of intervention reflects instead uncertainty both about what types of inter- vention would be desirable and about who should intervene when one of the parties to the loan contract is, either implicitly or explicitly, a national govern- ment. The response to the debt crisis of the 1980s has removed one of the two areas of uncertainty. The World Bank and the International Monetary Fund (IMF) have been recognized as the appropriate agencies for addressing the problems in this market. According to Zedillo, "Except for a few cases, debt arrange- ments have been explicitly linked to the design of and compliance with Fund- supported stabilization programs. It is not an exaggeration to say that ... the Fund has regained its foremost position in the handling of problems affecting global financial stability" (1986, p. 32). The remaining issue, then, is what sort of intervention is necessary? What should be done about the immediate debt crisis? And what should be done to improve the future functioning of this market? A great deal has been written on the first question. This article focuses on the second issue: how can we im- prove the way the market for developing country debt functions? Many studies designed primarily to focus on other questions shed light on the issues that are central to this article. None, however, analyzes all the implications of the short- comings in this market, leaving a substantial gap in our understanding of the problem and of an efficient solution to it. Although the shortcomings in this market have been addressed by academic economists, it is not clear that economic policymakers share their concern. In discussing the international debt crisis, influential members of the Federal Re- serve System have deemphasized the importance of the way this market func- tions. Manuel Johnson, vice chairman of the Board of Governors of the Federal Reserve, asserts that "there is broad consensus that we have a ... problem because... borrowers and lenders agreed to loans that appeared rational .... These loans turned out to be problems when real interest rates shifted sharply upward at the same time export revenues . .. became substantially less than an- ticipated" (1987, p. 3). His discussion of steps for resolving this crisis says noth- ing about improving the functioning of the market. And in the 1987 annual report of the Federal Reserve Bank of New York, Frydl and Sobol argue that debt policy has "two major and interrelated goals: (1) to improve [the] econom- ic and financial performance [of the developing countries] with a view toward sustaining economic growth and ... restoring ... creditworthiness ... and (2) to reduce the vulnerability of the international banking system to risk on [devel- oping country] loans" (1988, p. 6). No mention is mlade of any need to improve 192 The World Bank Research Observer, vol. 6, no. 2 (July 1991) the functioning of the market itself. Finally, Gerald Corrigan (1988), president of the New York Federal Reserve Bank, lists five requirements for resolving the debt problem; not one addresses shortcomings in the credit market. Thus either the problems discussed here are not recognized or they are not acknowledged. This article describes the significance of the market's short- comings. The first section looks at the main problem in this market-the un- enforceability of contracts-and examines the implications for loans, interest rates, maturity structures, and economic activity. After analyzing the effects of incomplete information regarding the borrowers' ability to pay, willingness to pay, and use of the loan proceeds, the article discusses the prospects for re- solving these problems and the effects of proposed solutions to the debt crisis. Unenforceability Developing countries borrow for several reasons. Eaton and Gersovitz (1982) describe four primary motives: to smooth consumption, to invest (if domestic returns exceed the world cost of funds), to facilitate international transactions, and to ease the transition to a new economic environment. These motives are not unlike those of borrowers in many other credit markets. But the market for developing country debt differs from the market for other debt for several reasons, the most important of which is that the debt is unenforceable. In most credit markets, if the borrower refuses to pay the lender can take the borrower to court. As long as the borrower is solvent, the courts will force the borrower to pay the debt, even if the borrower has to liquidate assets. In the market for developing country debt, however, creditors do not have this option. In the event of a default, there is no court with both the jurisdiction and the power to force repayment of the loan. The implications of this situa- tion are enormous. Imagine, for example, a mortgage market in which no court could force borrowers to repay their loans. Although it is customary to refer to these loans as unenforceable, the term is actually a bit too strong; creditors do have limited enforcement options. As Bulow and Rogoff (1986) point out, creditors' claims are recognized in Western courts. Thus a defaulting country's ships, planes, goods and money in transit, and assets abroad may be subject to seizure. This power does not, however, resolve the problem of unenforceability. As Gersovitz (1985) notes, the Demo- cratic People's Republic of Korea has serious debt problems, but it continues to engage in international trade. When it makes payments, no effort is made to seize the funds in the process of transition. Indeed, Gersovitz argues, only in the case of Iran in 1979-80 has any attempt been made to seize a country's assets abroad to pay its debts. And even this case does not demonstrate the independent use of existing enforcement powers to collect on defaulted debt. Political pressure presumably played a major role in persuading the banks to use their powers of enforcement. John Wakeman-Linn 193 Thus, for whatever reason, creditors are not using the limited powers of en- forcement they have. Hellwig (1986) provides a possible explanation for this failure. He points out that at the time the loan is made, the creditor wants to threaten the most serious possible penalties in case of default. At the time of default, however, the creditor wants to avoid taking the debtor to court, since the creditor would be obliged to write down the value of the debt to zero, a result the banks prefer to avoid. Even if these enforcement procedures were used, it is not at all clear that the loans could be recouped. The penalty a country suffers from default may be quite small relative to the debt owed. According to Bulow and Rogoff (1986), debtor countries can choose between paying the loan, not paying and incurring whatever costs are imposed through seizure abroad, or not paying and revert- ing to autarky. (Realistically, this last option would mean that the defaulting country could trade only with countries that woulcl not attempt to enforce out- standing debt claims.) Nordhaus (1986) points out that debtor countries have yet another option. Because in equilibrium the borrower will be relatively indifferent to the options of defaulting or paying, while the lender will be very concerned about repay- ment, the borrower can use this leverage to negotiate a partial default. Nordhaus argues that the incentives are such that we should never see a com- plete default; it seems that the incentives are such that complete repayment of a loan is also unlikely. Lomax (1986) points out that this potential for partial default is somewhat constrained by the fact that banking laws prevent creditors from making concessions that depart too sharply from normal commercial terms. Could collateral requirements help resolve the problem of enforceability? Even if mortgage loans were unenforceable, say, as long as creditors could effectively use the house as collateral, the loan would be virtually enforceable. Could the same solution work in the market for developing country debt? Un- fortunately, no. As Eaton, Gersovitz, and Stiglitz (1986) argue, collateral held in the debtor country cannot be seized in case of default, and collateral held abroad is of no value to the borrower. Thus any loan agreement must be what Eaton and Gersovitz (1982) refer to as "incentive compatible." That is, at the time the loan is made, the lender must believe that after the proceeds have been disbursed it will be in the borrower's interest to repay the loan. Indeed, Gersovitz (1985) argues that enforcement is the key problem in en- suring repayment of the debt. He argues that there are only three possible rea- sons for payment difficulties with any loan: the borrower lacks the resources to repay, or the borrower has a temporary liquidity problem, or the borrower simply refuses to repay. In the market for developing country debt, the first problem-solvency-is irrelevant. Gersovitz (1985) and Eaton, Gersovitz, and Stiglitz (1986) argue that countries virtually always have sufficient resources to repay their loans; their net worth is positive.1 Temporary liquidity problems should not cause payment 194 The World Bank Research Observer, vol. 6, no. 2 (July 1991) problems either, so long as the problem is correctly perceived by the creditors. Creditors in this case would simply make additional temporary loans. Thus repayment is a problem only if the country is unwilling-or is per- ceived to be unwilling-to service its debt. Creditors must be careful to design contracts that borrowers have an incentive to honor. The unenforceability of loan contracts reduces the welfare of all parties to the contract. Guesnerie (1986, p. 518) points out that "commitment is always in a sense preferable to noncommitment." Any contract that is possible without a firm commitment is feasible with a commitment; the borrower and lender simply agree to act as if commitment is not possible. The reverse is not true; many contracts that can be negotiated with a commitment cannot be concluded in the absence of a commitment. Cohen and Sachs (1986) demonstrate that when a country has the option of repudiating debt, its maximum rate of growth will be lower than it would have been had the debt been enforceable. This conclusion is consistent with Eaton and Gersovitz's (1982) observation that an increase in the penalties for default may actually increase the welfare of borrowing countries; new debt would car- ry a lower rate of interest, and loan flows would increase to reflect a lower probability of default. Obviously, if penalties for existing debt were increased and all else was unchanged, borrowers would be worse off. But the finding im- plies that a negotiated increase in default penalties in exchange for improve- ments in loan terms may also be a mutually beneficial way to deal with existing debt. However, as Swoboda (1985) notes, the market structure does not permit borrowers to surrender the option of repudiation. Thus an effective and cred- ible precommitment is not possible. How does unenforceability result in this decline in welfare and growth? Krugman (1985) has likened the market for developing country debt to the gen- eral credit market described by Stiglitz and Weiss (1981). They make the case that the probability of default results in some borrowers receiving as much as they would have otherwise, whereas other borrowers receive nothing. Kletzer (1986) compares the Stiglitz and Weiss analysis with that described by Jaffee and Russell (1976). The Jaffee-Russell notion is that each borrower receives a smaller loan as a result of the default probability than it would receive other- wise; the total volume of loans contracts as a result of the possibility of default. And Wakeman-Linn (1988) describes a variant on the Stiglitz-Weiss notion of credit rationing in which all borrowers receive some credit, but less than they would receive if the default probability were zero. This decline in loan volume is not surprising. As the amount of the loan in- creases, unless the potential cost of repudiation increases at least dollar for dol- lar, the probability of repudiation rises. The penalties, such as they are, are unlikely to increase dollar for dollar with the loan amount. In a world of cer- tainty, at some level the debt burden is so large that repudiation is the preferred option; therefore, loans would never exceed that amount. In reality, where un- certainty exists, the probability that repudiation will be the preferred option John Wakeman-Linn 195 for borrowers increases as the loan amount increases. Thus creditors have an incentive to keep loan amounts down. The impact of unenforceability on interest rates is even clearer. Since lenders always have the option of making risk-free loans, they will make these risky loans only if they carry a higher rate of interest. Thus the possibility of repu- diation increases the rate these countries must pay (see Wakeman-Linn 1988). Unenforceability also affects the maturity structure of the debt. According to Guttentag and Herring, "Debt repayment schedules are related less to the capacity of the borrower to repay than to the need to influence the borrower's willingness to repay" (1983, p. 217). Kletzer (1986) maintains that maturities are shortened as a way of enforcing some contract provisions. By requiring fre- quent renegotiation of the contract, the lender hopes to influence the borrower to use the funds in line with implicit or explicit contract provisions. Gersovitz (1985) argues that creditors prefer shorter maturities to facilitate their with- drawal from the market, should that become desirable. Thus "loan maturities tend to be shorter than those that are optimal from the standpoint of repay- ment capacity" (Guttentag and Herring 1983, p. 217). The observation that unenforceability reduces growth rates as well as loan volumes in the debtor country (Cohen and Sachs 1986) suggests that it also de- presses investment. Since unenforceability reduces the volume of loans available to a country, all activities that would have been financed with that additional credit suffer. Almost certainly some of these marginal activities would involve investment. Further, the increase in interest rates reduces investment. Invest- ments that pay an expected rate of return somewhere between the risk-free rate and the rate the debtor country has to pay will not be financed at this higher rate, but they would have been financed at the lower rate.2 Atkeson (1988) argues that the optimal contract, given the problem of un- enforceability, and assuming the debtor has more information about the use of the loan proceeds than the lender, calls for a net outflow of funds in times of low income. Atkeson's model shows that such a contract will increase invest- ment and reduce risk to the lender. This finding hinges on the proposition that there is only one type of potential investment for borrowers. As Gersovitz (1985) points out, in a market with unenforceable debt, it is generally not clear that investment by the borrower will reduce the risk to lenders. If bor- rowers invest in export-oriented industries or other areas that increase the borrower's susceptibility to penalties, there is less risk and lenders are better off. But if, for example, lenders invest in foreign exchange or import-compet- ing industries, the borrower is less susceptible to penalties and creditors are worse off. Since lenders have no effective way of binding borrowers in advance to a particular type of investment, lenders have no incentive to design a contract that encourages investment. Lacking such encouragement, the higher interest rates and lower loan volumes will discourage investment. 196 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Finally, the unenforceability problem can explain a puzzle in this market. In any credit market we would expect borrowers to take out loans when income is low and repay the loans when income is high. But the developing country debt market does not appear to work this way. Indeed, the major criticism of Eaton and Gersovitz (1981) is that their model assumes countries borrow in bad times and repay in good times. In fact, as Bulow and Rogoff (1986) and Gersovitz (1985) point out, countries do the opposite. Why? Atkeson provides one possible answer: contracts are structured this way to encourage investment. As discussed above, however, it is not clear that the argument is applicable giv- en the multiple investment opportunities available to borrowers. There is a more fundamental cause for this perverse timing, based directly on unenforceability. In their analysis of defaults in the 1930s, Eichengreen and Portes (1986) point out that countries that defaulted tended to be those that were hardest hit by declining terms of trade, and those with the highest debt- service burdens (and the most expansionary fiscal policies). The risk of default is clearly higher when income falls: the welfare benefits of repudiation increase while the costs fall with declining trade. This is particularly true if a decline in income today lowers expected future income. As both the Stiglitz-Weiss (1981) and Jaffee-Russell (1976) models show, an increase in risk tends to reduce the optimal size of the loan. If countries are already at or above the creditors' perspective of optimal loan size, the creditors may insist on net repayment when the debtor country's income declines. But creditors must be careful not to call for a net repayment large enough to prompt the country to default immediately, even if such repayment is consistent with the terms of the loan contract. Although declining income prompts bor- rowers to desire larger loans, the possibility of default prevents lenders from providing additional funds. As Eaton and Gersovitz (1980) point out, most de- veloping countries would like to borrow more at existing rates of interest. These borrowers cannot get additional funds by offering to pay higher interest rates. Thus the perverse timing that aggravates the effects of income swings is a direct result of the unenforceability of these loans. Information Asymmetries There are three types of information about which lenders and borrowers have unequal information: ability to pay, susceptibility to penalties and will- ingness to pay, and the use of the loan proceeds. "Ability to pay" is simply whether the country has sufficient resources to pay the loan if it chooses to liquidate those resources. In this sense, a country may technically be able to pay its debts, but political sentiment bars the gov- ernment from liquidating the necessary resources. For example, it has been ar- gued that Ecuador could sell its oil reserves to pay its foreign debt. The politics John Wakeman-Linn 197 of this proposal are at least as important as the economics. Thus it becomes a question of willingness to pay. Information about Ability to Pay Often a creditor's major concern is the debtor's ability to repay the loan. Since most debt contracts are enforceable, as long as the debtor has sufficient assets to repay the loan, the creditor will get paid. In the market for developing country debt, however, ability to pay is not a significant issue. As Eaton, Gersovitz, and Stiglitz (1986) point out, countries are likely always to have suf- ficient resources to repay the loan. Whether the country is willing to liquidate assets or do whatever else is necessary to pay the loan is a separate question. Thus information regarding ability to pay is largely irrelevant. There are two important qualifications to this statement. First, Gale and Hellwig (1985) show that, when there are costs for the lender to observe the borrower's situation, asymmetric information regarding ability to pay guaran- tees that the standard debt contract is the optimal arrangement. Debt is pref- erable to equity in this situation because, with a debt contract, observation costs are incurred only when the borrower claims an inability to pay the debt. With an equity contract, the observation costs must be incurred each period so the investor can be sure of getting the appropriate payment. Thus asymmetric information about ability to pay helps explain the preponderance of debt, as opposed to equity, in this market. Second, Diwan (1987) shows that a contract that is contingent on the state will maximize loan size. As an example he cites the 1986 IMF renegotiations with Mexico, under which the amount of the loan was contingent on the price of oil. But as Bulow and Rogoff (1986) point out, fully contingent contracts are not possible, since they would have to be contingent on private information. The implications of this information asymmetry are in general difficult to dis- cern. Diwan proves, however, that the lender's inability to write fully contin- gent contracts is reflected in smaller loans. Willingness to Pay Since countries must choose to pay this unenforceable debt, it is critical that creditors have information about the debtors' susceptibility to penalties and willingness to pay. Such information, however, is virtually impossible to assess accurately since it depends on a host of economic, political, and sociological factors. Lenders' perceptions of economic factors, such as a country's current economic situation, trade flows, and interest rates should be accurate, since outside lenders are generally as well informed about a country's economic pros- pects as domestic politicians (Eaton, Gersovitz, and Stiglitz 1986). But political and sociological influences may be harder to assess, and equally-if not 198 The World Bank Research Observer, vol. 6, no. 2 (July 1991) more-important. PoliticaLl pressures for reform and the effect of the popula- tion's attitude toward the debt clearly affect a country's willingness to pay, but the effect is hard to quantify. Lenders have developed some statistical models that attempt to evaluate the safety of loans to particular countries, but they are not based on an accurate understanding of country risk (Eaton and Gersovitz 1982). The investors can hardly be faulted for this failure, since as Guesnerie (1986) points out, contract theory provides no model that can explain this risk. Inadequate information regarding risk contributed to what many now believe to be the overlending before 1982. Guttentag and Herring (1984) con- clude that banks lent so much because they perceived that the risk and covari- ance of such loans were low. They were supported in this belief by economists. Diversifying loan portfolios across developing countries was considered a valid approach since, according to Goodman (1981), common risk is small relative to country risk, and export performance across developing countries tends to be uncorrelated (Eaton and Gersovitz 1981). The experience of the 1980s has shown the weaknesses in these arguments. The politics of trade, recessions in developed countries, and such major shocks as the changes in oil prices of the 1970s and 1980s can adversely affect many borrowers simultaneously; renegotiation with one country increases the pres- sure for similar talks with others. We are not much better able to assess risk today than we were ten years ago; changes make estimates of risk based on past experience unreliable (Guttentag and Herring 1984). Lacking theoretical models to explain how debtor countries decide whether to default or repay, we cannot accurately assess the risk of loans to any particular country. In addition to risk, creditors in this market also face uncertainty. The risk is that there is some probability of default. To this extent, the market is similar to the market for most debt; there is generally some risk that lenders have to be enticed to accept. The uncertainty stems from the lender's inability to dis- cern the borrower's intention to pay and therefore the probability of default. Any analysis of this market is thus confronted with uncertainty as well. What is the effect on the market of inadequate information regarding will- ingness to pay? If lenders overestimate the risk involved, interest rates will be too high, loan amounts too low, and investment and economic activity in the borrowing country will be depressed. If they underestimate the risk, the oppo- site will occur. In the view of Guttentag and Herring (1984), banks tend to underestimate the risk. They argue that: disaster myopia, miscalculations, and government guarantees make lenders act as if there is virtually no risk involved. If lenders overestimate the risk, high interest rates will prevent profitable in- vestments from being undertaken. If lenders underestimate the risk, welfare comparisons are difficult to make. Although the borrower will obtain financing for projects with an expected return to the lender that is below the lender's opportunity cost of funds, the expected return to the project itself exceeds this John Wakeman-Linn 199 opportunity cost. Borrowers are better off, the lender is worse off, and there may be no Pareto-improving trades possible. Information about Use of the Loan Creditors are often concerned about how borrowmers use the borrowed funds, since that can affect the borrower's ability to repay the loan. In the market for developing country debt, creditors are concerned about the use of the loan pro- ceeds because it may affect the borrower's willingness to repay the loan. Eaton, Gersovitz, and Stiglitz (1986) contend that although creditors need not worry about solvency, it is important to pay attention to the way funds are used (and to other activities in the country). These actions may affect the borrower's sus- ceptibility to penalties, or the likelihood of imposition of penalties, and thus affect the probability of repayment. Ideally, creditors would like the option of making loans that constrain the borrower's behavior. But there is no possibility of ensuring an effective and credible commitment (Krugman 1985). Even if such a contract were signed, it would suffer from the same problems of unenforceability as the general con- tract. And since creditors are concerned about borrower behavior insofar as it affects their willingness to adhere to the unenforceable contract, the unenforce- able precommitment is of no benefit. Without constraints on borrower behavior after the loan has been made, borrowers will act in their own self interest. This may involve actions that di- minish their willingness to pay and exacerbate the unenforceability problem, with familiar repercussions for loan quantities, interest rates, maturities, and general welfare. The Atkeson (1988) argument for timing credit flows to influ- ence investment levels focuses on precisely this issue: the use of the loan as it affects the willingness to pay. And the Kletzer (1986) argument for shorter maturities stresses attempts to influence the use of loan proceeds. Conclusion Most discussions of the market for developing country debt focus on the cri- sis in this market: What do we do about the huge volume of outstanding debt that may never be repaid and that is inhibiting growth in the developing coun- tries? This article focuses on what has been referred to as a quiet crisis: the international misallocation of capital. Investments that pay rates of return greater than the opportunity cost of funds to creditors are not being financed, while investments with lower rates of return are being financed elsewhere with enforceable contracts. And this outcome would persist even if, by some miracle, the existing debt burden were eliminated. Is it possible to correct these shortcomings? There is no way to make these contracts enforceable, barring the elimination of national sovereignty. And it 200 The World Bank Research Observer, vol. 6, no. 2 (July 1991) seems impossible to reduce the important information asymmetries: informa- tion about a borrower's willingness to pay and about the anticipated use of loan proceeds is private. That leaves only one option: enforcement. If the pen- alties for default on future loan contracts were more certain or more harsh, the problem would be less severe and all parties would benefit from the improved international allocation of capital. The limited powers of enforcement available to creditors are almost never used, at least in part because of regulatory implications. Thus one option is to change the regulatory structure that discourages creditors from declaring a country in default and attempting to impose penalties. Although it is not clear that such a change would have a significant effect on this market, given the meager enforcement powers that exist, it would be a step in the right direction. More fundamental improvement would have to come from some attempt to increase the penalties for clefault; it is not immediately clear how (if at all) that could be done. What is clear, unfortunately, is that most existing procedures for dealing with the debt overhang, with their implicit or explicit debt reduc- tion, reduce the perceived penalties for default. Although these proposed solu- tions may ease the debt burden, they send the signal that the penalties for default are lower than before, thus compounding the problem of misallocation of capital. The Brady Plan, market value buybacks, and debt-equity swaps that involve debt reduction are all subject to this same criticism. Ideally, we would find a way to resolve both crises in this market. But, at a minimum, we need to find a way to reduce the debt burden without simultaneously aggravating the quiet crisis. Notes John Wakeman-Linn is assistant professor of economics at Williams College, in Williamstown, Massachusetts. 1. This may not be true for what Mohammed (1986) refers to as the "official borrowers" of Sub- Saharan Africa. However, since this article is focusing on the market for developing country debt, the borrowers we are concerned about are those Mohammed refers to as "market borrowers." 2. This argument assumes that the debtor country, at the time it takes out the loan and uses the proceeds, intends to repay the loan or has the same expectations as the lender regarding the probability of default. If the debtor intends not to repay the loan in full or has different expec- tations than the creditor regarding the probability of default, the effective interest rate the debtor faces may be less than the risk-free rate. It can easily be demonstrated (see Wakeman-Linn 1989) that, even in this case, investment would decline. Facing a binding credit ceiling, investment is not determined by the interest rate on loans. Rather, the level of investment is chosen to equate the marginal product of capital with the ratio of marginal utility of consumption across time periods. The declining loan volume will reduce investment. References The word "processed" describes informally reproduced works that may not be commonly available through libraries. John Wakeman-Linn 201 Atkeson, Andrew. 1988. "International Lending with Moral Hazard and Risk of Repudiation." Stanford University, Graduate School of Business, Stanford, Calif. Processed. Bulow, Jeremy I., and Ken Rogoff. 1986. "A Constant Recontracting Model of Sovereign Debt." NBER Working Paper 2088. National Bureau for Economic Research, Cambridge, Mass. Processed. Cohen, Daniel, and Jeffrey Sachs. 1986. "Growth and External Debt under Risk of Debt Repu- diation." European Economic Review 30: 529-60. Corrigan, E. Gerald. 1988. "A Balanced Approach to the LDC Debt Problem." Federal Reserve Bank of New York Quarterly Review 1, no. 13: 1-7. Diwan, Ishac. 1987. "Contract Design and Credit Rationing in International Lending to LDCs." Working Paper 419. Salomon Brothers Center for the Study of Financial Institutions, New York University Graduate School of Business Administration, New York. Processed. Eaton, Jonathan, and Mark Gersovitz. 1980. "LDC Participation in International Financial Markets: Debt and Reserves." Journal of Development Economics 7: 3-21. - 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis." Review of Economic Studies 48: 289-309. . 1982. "Country Risk: Economic Aspects." Yale University Economic Growth Center Dis- cussion Paper 401. New Haven, Conn. Processed. Eaton, Jonathan, Mark Gersovitz, and Joseph Stiglitz. 1986. "The Pure Theory of Country Risk." European Economic Review 30: 481-513. Eichengreen, Barry, and Richard Portes. 1986. "Debt and Default in the 1930s: Causes and Con- sequences." European Economic Review 30: 599-640. Frydl, Edward J., and Dorothy M. Sobol. 1988. "A Perspective on the Debt Crisis." In Federal Reserve Bank of New York, Annual Report 1987. New York. Gale, D., and Martin Hellwig. 1985. "Incentive Compatible Debt Contracts: The One Period Problem." The Review of Economic Studies 52: 647-64. Gersovitz, Mark. 1985. "Banks' International Lending Decisions: What We Know and Implica- tions for Future Research." In Smith and Cuddington. Goodman, Laurie S. 1981. "Bank Lending to Non-OPEC LDCs: Are Risks Diversifiable?" Federal Reserve Bank of New York Quarterly Review (Summer): 10-20. Guesnerie, R. 1986. "The Pure Theory of Country Risk: ComLment." European Economic Review 30: 515-19. Guttentag, Jack M., and Richard J. Herring. 1983. "What Happens When Countries Cannot Pay Their Bank Loans? The Renegotiation Process." Journal of Comparative Business and Capital Market Law 5: 209-31. 1. 984. "Commercial Bank Lending to Developing Countries: From Overlending to Un- derlending to Structural Reform." Brookings Discussion Paper in International Economics 16. Brookings Institution, Washington, D.C. Processed. Hellwig, Martin. 1986. "The Pure Theory of Country Risk: Comment." European Economic Review 30: 521-27. Jaffee, Dwight, and T. Russell. 1976. "Imperfect Information and Credit Rationing." Quarterly Journal of Economics (November): 651-66. Johnson, Manuel H. 1987. "Reflections on the Current International Debt Situation." Federal Reserve Bank of Kansas City Economic Review 3, no. 8: 3-8. Kletzer, Ken. 1986. "External Borrowing by LDCs: A Survey of Theoretical Issues." Yale Univer- sity Economic Growth Center Discussion Paper 523. New Haven, Conn. Processed. Krugman, Paul. 1985. "International Debt in an Uncertain World." In Smith and Cuddington. Lomax, David. 1986. "A Banking Perspective." In Posner. Mohammed, Azizali E 1986. "The Debt Problem." In Posner. 202 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Nordhaus, William D. 1986. "Growth and External Debt under Risk of Debt Repudiation: Comment." European Economic Review 30: 561-64. Posner, Michael, ed. 1986. Problems of International Money 1972-1985. Washington, D.C.: International Monetary Fund Overseas Development Institute. Smith, Gordon W., and John T. Cuddington, eds. 1985. International Debt and the Developing Countries. Washington, D.C.: World Bank. Stiglitz, Joseph, and Andrew Weiss. 1981. "Credit Rationing in Markets with Imperfect Infor- mation." American Economic Review (June): 393-410. Swoboda, Alexander K. 1985. "Debt and the Efficiency and Stability of the International Finan- cial System." In Smith and Cuddington. Wakeman-Linn, John. 1988. "Alternative Notions of Credit Market Equilibrium and Their Implications for Monetary Policy." Williams College Research Paper 119. Williamstown, Mass. Processed. . 1989. "Shortcomings in the Market for Developing Country Debt." PPR Working Paper 268. World Bank, International Economics Department, Washington, D.C. Processed. Webb, Kerry. 1980. "The Farm Credit System." Federal Reserve Bank of Kansas City Economic Review (June): 19. Zedillo Ponce de Leon, Ernesto. 1986. "A Borrower's Perspective." In Posner. John Wakeman-Linn 203 THE RELATIVE EFFICIENCY OF PRIVATE AND PUBLIC SCHOOLS IN DEVELOPING COUNTRIES Emmanuel Jimenez Marlaine E. Lockheed Vicente Paqueo Aside from revenue mobilization, one of the arguments for allowing the private sector to assume a larger role in the provision of education is that it would increase efficiency, as administrators become more responsive to the needs of students and their parents. But what is the evidence? Based on case studies that compare private and public secondary education in Colombia, the Dominican Republic, the Philippines, Tanzania, and Thailand, private school students generally outperform public school students on standardized math and lan- guage tests. This finding holds even after holding constant for the fact that, on average, private school students in these countries come from more advantaged backgrounds than their public school counterparts. In addition, preliminary evidence shows that the unit costs of private schools are lower than those of public schools. Although these results cannot, in themselves, be used as argu- ments for massive privatization, they indicate that governments should recon- sider policies that restrain private sector participation in education. Further research is needed to determine whether some teaching and administrative practices in private schools are applicable to public schools. M ost developing countries provide public education at the elementary and high school levels. Such schools enroll approximately 90 percent of primary and 70 percent of secondary school students and are free, or almost free. But tightening fiscal constraints in many countries have limited The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 205-218 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 205 the public sector's ability to expand free public education, creating a particu- larly serious problem for the poorest countries, where demand for schooling is projected to increase dramatically in the coming decades. One possible solution is to charge a tuition fee for public school, and rnany countries have adopted this policy. Another option is to rely on private schools to handle at least part of the expansion by relaxing restrictions on establishing or expanding private schools, providing loans to and information about them, and restricting the number of available places in public schools. Studies suggest that such policies would not only generate more resources for education but could also lead to greater effi- ciency and improved quality (World Bank 1986). Private schools compete for students, after all, and are accountable to parents who pay the bills. This view holds that private schools have an incentive to adopt teaching practices and use staff and educational materials effectively and economically. And, if public schools were also forced to compete with private schools for students, they too might become more efficient. But what is the empirical evidence regarding the relative efficiency of private and public schools? In the United States, the provocative Coleman, Hoffer, and Kilgore (1982) report concluded that attending private schools increased the performance of students as measured by standardized tests of verbal and math- ematical skills. Although there are outstanding questions of selectivity bias and the magnitude of effects (see, for example, American Sociological Association 1983; Murnane 1985; Murnane, Newstead, and Olsen 1985), the conclusion that the average student does better in private than in public school is wide- spread (Hanushek 1990). For developing countries the evidence is much more recent. In this article we summarize the results of the few studies that rigorously compare private and public school costs and achievement in developing countries.' These studies were sponsored by a World Bank research project and analyze data on second- ary schools in several educationally diverse countries: Colombia and Tanzania (Cox and Jimenez 1989), the Dominican Republic (Jimenez and others 1989), the Philippines (Jimenez, Paqueo, and de Vera 1988), and Thailand (Jimenez, Lockheed, and Wattanawaha 1988). These papers share a number of characteristics, of which the two most im- portant are a common methodology and comparable results. The common methodology is important for two reasons. First, in attributing differences between the cognitive achievement of students in public and private schools to school resources alone, it is important to control for such nonschool factors as family background and to ensure that there is enough overlap in the charac- teristics of the students so that the subsamples are truly comparable. And sec- ond, to obtain efficiency, differences in achievement must be compared with differences in cost. Although these studies are the only ones at present that rely on this methodology, the few studies that apply parts of it corrobo- 206 The World Bank Research Observer, vol. 6, no. 2 (July 1991) rate our results (Luna and Gonzalez 1986; Psacharopoulos 1987; Tsang and Taoklam 1990). Despite the diversity of the country case studies, the results are similar. * When student background and sample selection biases are held constant, students in private schools outperform students in public schools on verbal and mathematics achievement tests. * The unit costs of private schools are less than the unit costs of public schools. Methodology and Data All five country case studies reviewed address this question: Would a high school student, selected at: random from the general student population, do better in a public or private school? In the absence of experimental data, a re- liable answer can be obtained from a cross-section comparison of public and private school students' performance on standardized tests-when student background, motivation, and innate ability are controlled through statistical techniques. The Empirical Framework A simple comparison of the average student's score on a standardized test is generally not a fair evaluation of the difference between public and private schools for several reasons. First, there are methodological issues. The back- grounds of public and private school students are generally different, and this may affect the results. For example, private school students may do better, not because of the school, but because their parents provide an environment that is more conducive to scholarship. To make a proper comparison of public and private schools, then, the analyst must purge the influence of background fac- tors from the achievement scores. The statistical technique used in these studies (see the appendix for an explanation of the model) measures the differences in public and private school achievement for a given level of background variables. But what if the analyst cannot reliably measure some background variables? For example, parents' education may be a good measure of the home environ- ment's effect on achievement, and this variable can be measured. But it may be impossible to measure all the nonschool or family background effects (for in- stance, motivation). One strategy is to use panel data and compare the differ- ences in public and private achievement over two time periods. Nonschool effects that do not change over that time are netted out. The studies of the Dominican Republic and T'hailand use change in achievement across two time periods rather than the level of achievement in a given time period. As far as we know, analysts have published this type of value-added results for only one Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 207 other data set (for U.S. high schools, see Coleman, Hoffer, and Kilgore 1982; Lee and Bryk 1988; and Hanushek 1986). Another important methodological issue is selection bias. Statistical compar- isons, such as those described above, may be biased if observed samples were preselected into each type of school in a systematic way. For example, suppose that only the most motivated parent living in a low-income neighborhood sent his or her child to a private school rather than to a public school. Using the ordinary model to predict how this student would perform in an alternative system might be misleading. All the studies reviewed here use standard statis- tical corrections (Heckman 1979; Willis and Rosen 1979) to eliminate selection bias. A final methodological contribution is that the Dominican Republic study- unlike most of the studies-differentiates between types of private schools. This is important since observers claim that differences in the quality and type of private schools make it difficult to compare them with more homogeneous public schools. The two types of private schools are the more prestigious schools (F-type), which are authorized to give Ministry of Education examina- tions, and the ordinary, or 0-type, schools, which are not. Data Each of the papers relied on data collected for other purposes. The data on Colombia and Tanzania were generated from a World Bank study of diversified education (see Psacharopoulos and Loxley 1985). The Philippines data were collected by the Ministry of Education as part of its Household and School Matching Survey. The Thailand data were obtained from the Second Interna- tional Mathematics Study conducted by the International Association for the Evaluation of Educational Achievement (IEA) (see Robitaille and Garden 1989), and the Dominican Republic data came from a survey modeled after the lEA's (Luna and Gonzalez 1986). Despite their varied origins, the data sets contained similar core information. The main components are household and student characteristics and scores on standardized tests of verbal skills or mathematics or both. In the Dominican Republic and Thailand, extensive data were available on teaching practices and school and teacher characteristics, and test scores were available for students for the beginning and end of the school year. In Colombia, the Philippines, and Tanzania, the results were supplemented by data on mental ability. Table 1 summarizes the salient features of the data. Findings The two principal sets of findings concern relative access to public and pri- vate schools and student achievement. 208 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Table 1. Summary of Studies Country and Year data Indicator of study collected Students Schools Grade achievement Data base Colombia 1981 1,004 129 11 Average scores Special (Cox and Jimenez 1989) on math and survey verbal tests Dominican Republic 1982-83 2,472 76 8 Mathematics National (Jimenez and others 1989) test school survey Philippines 1983 446 - 7-10 Mathematics National (Jimenez, Paqueo, and test household de Vera 1988) English test survey Pilipino test Tanzania 1981 1,124 57 11 Average scores Special (Cox and Jimenez 1989) on math and survey verbal tests Thailand 1981-82 4,030 99 8 Mathematics National (Jimenez, Lockheed, and test school Wattanawaha 1988) survey - Not available. Choice of School Unless there is excess demand for places, students and their parents choose the type of school to attend based on costs and benefits. If school places are rationed, the schools' selection criteria determine which applicants are accepted. Because the private schools in the sample countries charge tuition while the public schools are almost free, the most important factors in the household de- cision are income (or incoime-related variables such as parents' education and occupations) and the relatjive cost of schooling. According to table 2, average income indicators for students in private schools are about twice as high as those for students in public schools in Colombia and the Philippines. Interest- ingly, in Tanzania, this difference is much lower, which suggests that public schools attract students from higher-income families. These findings are cor- roborated by data showing that private school students in Tanzania tended to come from families where the father had a white-collar job and the mother had some education. The range in income, however, is only slightly higher for pri- vate than for public school students in Colombia, and lower in Tanzania and the Philippines, which suggests a substantial overlap in the income categories of the public and private school samples. The quality-adjusted price of attending the two types of schools is very dif- ficult to measure. Tuition tends to reflect school quality, which itself is a dimension of school choice. Thus we did not include this variable, even when available. In the Philippine study, however, we used the relative distance of Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 209 Table 2. Background Indicators for Private School Students as a Multiple of Indicators for Public School Students Dominican Republica Indicator Colombia 0-type F-type Philippines Tanzania Thailand Income (of household head 1.94 - 2.07 1.20 or father) Coefficient of variation 1.24 - - 0.72 0.83 of income Mother's education 1.87 1.62 2.21 1.23 1.27 1.61 (percentage beyond primary) Father's occupation 1.09 1.69 2.52 - 1.50 1.94 (percentage white collar) Percentage male 1.04 1.29 1.78 0.98 1.07 0.91 - Not available. Note: The table shows the extent to which an indicator for private school students exceeds that for public school students. For example, in Colombia, the average household-head income of students in private school is 1.94 times (almost twice) that of students in public school. A figure close to one implies that an indicator for private school students is equal to that for public school students. a. F-type schools are authorized to give Ministry of Education examinations. 0-type schools are not so authorized. public and private schools from each household as a measure of household cost. This variable was highly significant in explaining school choice. Although many private schools are sectarian, religion is not included as an explanatory variable because in most countries all the students are of the same religion. Gender can be an important determinant of school choice, since some parents prefer single-sex schools and the private system has a higher proportion of these schools (Lee and Lockheed 1990). In Colombia, the Dominican Republic, and Tanzania more males attend private schools; in Thailand and the Philippines females predominate in private schools. In sum, the average private school student comes from a more advantaged background than his or her public school counterpart. The magnitude of this advantage, however, varies across countries. Also, despite the difference in the averages, the overlap in the range of public and private indicators is significant, so that there are students from advantaged backgrounds in both public and pri- vate schools. We have used these findings to make conclusions about selecting different types of schools-and to correct for possible biases in the achievement equa- tion. In the only study that contained strict cross-country comparisons- Colombia and Tanzania-correcting for sample selection bias revealed that Colombian students tended to choose the type of school where they would prosper, while Tanzanian students were positively selected into the public sys- tem. This finding is important because in Tanzania, student choice is more lim- ited and public schools are viewed as elite (Samoff 1987). 210 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Relative Efficiency of Public and Private Schools Do private schools provide a better education than public schools? A prin- cipal finding of these studies is that, given student background, students in pri- vate schools generally outperform their public school counterparts on standardized mathematics or language tests, or both. The calculation is as fol- lows. The predicted scores in each type of school are obtained from the regres- sion equations relating background to achievement, as evaluated at the level of background characteristics of the average public school student. This effective- ly holds constant for the effects of background. Table 3 shows the ratio of a student's predicted score in a private school to his or her score in a public school. For example, in Colombia, a student with the background of the aver- age public school student would score 1.13 times (13 percent) better in a private school than in a public sc]hool. This ratio varies considerably across countries but is consistently greater than one for all subsamples and achievement tests (with the possible exception of mathematics achievement in the Philippines, where the differences are insignificant). The phrase "given student background" is critical here. It is generally not valid to infer differences among types of schools based on a simple comparison of achievement on standardized tests because students' backgrounds vary so much between types of schools. As explained in the preceding section, in these comparisons we hold the background effects constant by measuring achieve- ment at the average characteristics of public or private school students. In fact, the advantage conferred by private schools is greater for the two countries with the best controls for student background-the Dominican Republic and Thailand. The data sets for these students contain test scores measured at the Table 3. The Private School Advantage: Predicted Test Score in Private School as a Multiple of Predicted Test Score in Public School Country Indicator of achievement Advantage Colombia Average math and verbal 1.13 Dominican Republica Mathematics (0-type) 1.31 Mathematics (F-type) 1.47 Philippines Mathematics 1.00 English language 1.18 Pilipino language 1.02 Tanzania Average math and verbal 1.16 Thailanda Mathematics 2.63 Note: The table shows the proportional gain in achievement score if a randomly selected student, with the characteristics of the average public school student, attends private rather than public school, holding constant that student's background. a. For the Dominican Republic and Thailand, the test score before the school year began was included as a regressor in the equation explaining achievement at the end of the year. Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 211 beginning and at the end of the school year, and the ratios measure change in achievement over the course of the academic year (with controls for possible sample selection bias). Some caveats should be noted. The case studies focus on secondary school students and may not hold for other levels, even in the same countries. More- over, it would not be valid to make any strict cross-country comparisons re- garding the magnitude of the results. The tests are not standardized across countries. And because the data sets were designed by different researchers, the student background variables being held constant are only roughly equivalent. Do these results hold for students from different socioeconomic groups? Qualitatively, the answer is yes. The private school advantage persists even when the computations in table 3 hold constant the background of the higher- status average private school student rather than that of the average public school student. The Philippine study is the only paper that looked at the sen- sitivity of the private-public differential to a wider range of socioeconomic in- dicators. The authors found that variations in socioeconomic status, within a reasonable range, did not reverse the effect of private school. But the magnitude of the private school advantage substantially decreases with lower socioeco- nomic status. This is consistent with the fact that the more elite private schools in the Philippines tend to emphasize the development of English-language skills and that advantaged children have more exposure to English and better access to English-language media. Among children who speak Pilipino, on the other hand, there is no relationship between socioeconomic status and private school. And in mathematics there is a virtual tie between public and private schools. What about efficiency? Preliminary calculations based on school expenditure data indicate that, on average, the unit costs for private schools are lower than those for public schools (table 4, column 1). Thus for the same unit cost, pri- vate schools provide as much as three times more learning as the public schools (table 4, column 2). Conversely, the same amount of learning in private schools can cost as little as 15 percent of its cost in public schools (table 4, column 3). These results indicate that private schools are more effective than public schools, at least for secondary schools in the sample countries. But there are some important caveats. First, the orders of magnitude are rough. The cost estimates for Colombia and Tanzania are not precise because a number of pri- vate schools did not provide the necessary information. Second, in the Philippines, we used the average cost for a nationwide sample of schools (based on World Bank sector work), rather than the actual cost of the schools in the study. By comparison, in the Dominican Republic and Thailand, we had school-by-school cost data for the sample. Third, the cost figures generally do not include educational expenditures that are not paid to schools, or the im- plicit subsidy provided by the priests and nuns teaching in sectarian schools. We do not, however, expect these data to significantly change the qualitative results. Generally, nonschool educational expenditures, such as books, supplies, 212 The World Bank Research Observer, vol. 6, no. 2 (July 1991) and uniforms, are higher in private schools. And interviews in the countries studied reveal that even religious private schools tend to use lay teachers rather than priests and nuns. Moreover, subsistence and other nonsalary personnel costs are covered in the cost data. Finally, there is considerable variability within each school type, as noted in the data on private schools in the Dominican Republic. Philippine public schools (say, those that are primarily locally funded) have lower unit costs than some types of private schools (the elite schools). Unfortunately, the survey data did not distinguish student achievement among types of public schools. It would be interesting in subse- quent analysis to explore this comparison. Why Is There a Difference between Public and Private Schools? The research attemptecd to assess the differences in private and public schools in the Dominican Republic and Thailand and, to a lesser degree, in Colombia and Tanzania. If the effectiveness of private schools could be repli- cated, public schools could adopt the same practices, permitting broad im- provement in the educational system. Table 5 compares some mean characteristics of private and public schools. Although it is not possible to infer causality from this table, some comparisons are interesting. For example, in Thailand private schools make more efficient use of teachers by recruiting candidates with slightly lower qualifications, giving them more in-service training, and promoting better teaching processes Table 4. Relative Average Cost and Efficiency of Public and Private Schools (2) (3) (1) Ratio of Ratio of Ratio of relative relative private cost to effectiveness cost to Country public cost to costa effectivenessb Colombia 0.69 1.64 0.61 Dominican Republic 0-type 0.65 2.02 0.50 F-type 1.46 1.01 0.99 Philippinesc Math 0.83 1.40 0.83 English 0.83 3.17 0.70 Pilipino 0.83 1.20 0.82 Tanzania 0.69 1.71 0.59 Thailand 0.39 2.62 0.15 a. Figures from table 2 divided by column 1 of table 3. b. Column 1 of table 4 divided by figures from table 2. c. Public cost estimates and weighted average of national and local costs. Costs are assumed to be the same for all three subjects and are based on World Bank estimates. Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 213 Table 5. Average Private School Teacher Characteristeics as a Multiple of Average Public School Teacher Characteristics in Four Countries Variable Ratio Colombia Teacher salary 0.52 Student-teacher ratio 0.85 Dominican Republic Teacher's years of education 0-type 0.95 F-type 1.02 Minutes spent maintaining class order 0-type 0.38 F-type 1.21 Proportion of students with textbook 0-type 3.11 F-type 3.50 Student-teacher ratio 0-type 1.00 F-type 1.00 Tanzania Teacher salary 1.15 Student-teacher ratio 1.07 Thailand Proportion of teachers Qualified to teach math in student's school 0.17 With in-service training 2.29 Teaching enriched math class 1.54 Spending more than 15 minutes a week maintaining order 1.24 Minutes spent weekly on quizzes and tests 1.45 Number of students per class 1.05 Note: The table shows, for example, that in Colombia teachers' salaries in the average private school are 52 percent of those in the average public school. (homework, tests, and orderly classrooms). In the Dominican Republic, the most striking difference is that students in private schools have better access to textbooks. In all countries, differences in student-teacher ratios are not very large. These findings are necessarily preliminary because it is very difficult to assign differences in achievement among resources whose uses are sometimes complementary. Do school and peer-group characteristics affect student achievement? In the Dominican Republic and Thailand, the only two countries for which data were available, peer-group effects (the academic background or social class of stu- dents in each school) were very important. However, even after all measurable school characteristics are held constant, some private school advantage persists. This advantage may reflect unmeasured 214 The World Bank Research Observer, vol. 6, no. 2 (July 1991) factors, such as school management practices-a conclusion that is consistent with the view that there are inherent incentives for private schools to be effi- cient because of greater accountability to parents. This conclusion has impor- tant implications for policy in public schools. Although some gains in efficiency can be obtained by mimicking the mix of resources (such as teacher-student ratios and teacher qualifications) of private schools, such actions are not likely to equalize the two systems. A more effective, albeit less transparent, policy measure would be to mimic the incentive structures (including decentralized control) inherent in private systems. Significance for Policy The findings cited in this article should not be interpreted as a call for the abolition and privatization of public schools. The findings are preliminary and need to be tested with other data sets in other environments. Also, the marginal differences found in the studies may not persist if many students moved from public to private schools. Still, the studies do offer initial empirical evidence on an issue that has been largely subject to speculation and often emotional de- bates. One immediate implication for policy is that overrestrictive regulations on private schools (including outright prohibition in some countries) may be suppressing an efficient way to provide education. Another implication for policy is that, in some cases, governments could en- courage greater private sector participation in education. It should be stressed, however, that the relative efficiency of private schools is highly dependent on the institutional regime and structure of incentives under which they currently operate. Government subsiclies, for example, may not necessarily lead to great- er efficiency in the educational system. Such subsidies could be associated with institutional changes that reduce the schools' ability to choose a suitable input mix and to strive for greater efficiency. The exact nature of those reforms that lead to improved efficiency and equity is beyond the concern of the present article. They might involve contracting for educational services (as is now being done in the Philippines), or even some form of voucher system as in Chile. Restrictive rules and regulations intended to protect consumers could be mod- ified, or tax exemptions could be granted for private schools. All such measures will have to be discussed in the larger context of the political economy of spe- cific countries (James 1987). A final implication for policy is that public schools could emulate at least some teaching and administrative practices of their private counterparts. The usual assumption in consiclering government policies toward private schools is that the quality of education they provide is not commensurate with what is being paid by the consumers, due to the asymmetry of information between consumers and providers. This widely held assumption is complemented by the view that bureaucrats have better information regarding the technology of Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 215 education. The evidence, however, is that private schools, which are more au- tonomous and responsive to students and their parents, will deliver education in a cost-effective way. Although the rigorous methodology used in the comparisons of public and private schools allows some clear advances in the literature, additional work is warranted. First, the data bases were not strictly comparable across countries and it is not possible to make cross-country generalizations. Second, the scope of countries covered is also limited. Third, better information, particularly re- garding the social and private costs of different kinds of schools, needs to be gathered. Fourth, it would be useful to compare results across the entire distri- bution of students rather than just for the average student. And finally, the studies covered only secondary schools. In Latin America and East Asia, the critical level for the future will be universities, which are the highest-cost components in many budgets for public education. In Africa and the Indian subcontinent, the issue is also being discussed for the primary level. Appendix: The Empirical Framework The ith private school student's achievement score A is a function of a vector of observed background variables X and unobserved variables e2 (la) Aip = bp Xip + eip, where each component of b measures the marginal effect of a characteristic on achievement. The jth public (or government) school student's score can be sim- ilarly expressed by replacing the subscript p with g: (lb) Ajg = bg Xjg + ejg. If the effects due to unobserved variables e are randomly and normally dis- tributed, ordinary least squares regression techniques can then be used to esti- mate the parameters of equations (la) and (lb). Comparisons between private and public schools can then be made using this information. For a student with the characteristic of the average public school student, the difference in achievement score if he or she were to attend a private school would be3 (2) Effect = (bp - bg) Xg. Thus such nonschool factors as socioeconomic background, innate ability, and individual motivation also affect achievement. Moreover, these nonschool factors affect the family's choice of school (selection bias). For example, if chil- dren from privileged backgrounds attend private schools exclusively, it would be difficult to infer how they would do in public schools. Statistically, this means that the error terms e are no longer norrnally distributed and ordinary least squares should not be used to estimate the above equations. To correct for sample selection, the papers use statistical corrections based on Heckman's (1979) two-step technique. First, a probit model is employed to 216 The World Bank Research Observer, vol. 6, no. 2 (July 1991) estimate the determinants of choice of school type. Second, the results of the first step are used to hold constant the probability of school choice in estimat- ing achievement (equations la and lb). The results are promising. The greatest difficulty in this technique is identification: at least one variable should be included in the first stage that is not in the second stage. This vari- able is called the exclusion restriction. In the Philippines study, for example, the relative distance to each type of school is used as such a restriction. Otherwise, the results hinge on specification to identify the parameters, and the coefficients could be unstable. In such a case, the models should be subjected to sensitivity analysis by including different subsets of variables in each stage of the analysis. Notes Emmanuel Jimenez is on the staff of the Country Economics Department of the World Bank, Marlaine E. Lockheed is on the staff of the Bank's Population and Human Resources Depart- ment, and Vicente Paqueo is on the staff of the Bank's Country Department V in the Asia Regional Office. 1. Other recent studies, such as Roth (1987), James (1987), and Samoff (1987), look at the private sector's role in providing education in developing countries but do not compare costs or achievement in private and public schools. Also see Jimenez and Lockheed (1991) for studies that examine public and private schooling issues more broadly. 2. Alternatively, equations (la) and (lb) can be estimated as one equation, with a dummy vari- able for private and public schools. However, statistical (F) tests led us to reject the hypothesis that the coefficients of all the other variables are equivalent in both types of schools. 3. This can be easily shown. Subtract the estimated equation (lb) from (la). Then, add and subtract bpXg on the right-hand side of the resulting equation. The resulting difference can be expressed as: Difference = bp (Xp - Xg) + (bp - bg), Xg, where the first term is interpreted as the endowment effect (that is, the difference in scores due to differences in characteristics) and the second term is the school effect shown in equation (2) above. References The word "processed" describes informally reproduced works that may not be commonly available through libraries. American Sociological Association. 1983. Sociology of Education 56, no. 4. Various articles on private and public schools. Coleman, James, Thomas Hoffer, and Sally Kilgore. 1982. High School Achievement: Public, Catholic and Private Schools Compared. New York: Basic Books. Cox, Donald, and Emmanuel Jimenez. 1989. The Relative Effectiveness of Private and Public Schools: Evidence from Two Developing Countries. Living Standards Measurement Study Working Paper 60. Washington, D.C.: World Bank. Also in Journal of Development Eco- nomics 34 (1990): 99-121. Hanushek, Eric. 1986. "The Economics of Schooling: Production and Efficiency in the Public Schools." Journal of Economic Literature 25 (September): 1141-77. Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo 217 - . 1990. "Issues in the Private-Public Split of Educational Provision." Paper presented at the Rockefeller Foundation-World Bank Conference on the Private Provision of Social Services in Developing Countries, Bellagio, Italy, October 22-26. Heckman, James J. 1979. "Sample Selection Bias as Specification Error." Econometrica 47 (January): 153-61. James, Estelle. 1987. "Public Policies toward Private Education." Discussion Paper, Education and Training Series, Report EDT84. World Bank, Washington, D.C. Processed. Jimenez, Emmanuel, and Marlaine E. Lockheed, eds. 1991. Private vs. Public Education: An International Perspective. Special issue of International journal of Educational Research 15. Jimenez, Emmanuel, Marlaine E. Lockheed, Eduardo Luna, and Vicente Paqueo. 1989. "School Effects and Costs for Private and Public Schools in the Dominican Republic." Policy, Planning, and Research Working Paper 288. World Bank, Populttion and Human Resources Depart- ment, Washington, D.C. Processed. Also in International Journal of Educational Research 15 (1991). Jimenez, Emmanuel, Marlaine E. Lockheed, and Nongnuch Wattanawaha. 1988. "The Relative Efficiency of Public and Private Schools: The Case of Thailand." World Bank Economic Review 2, no. 2: 139-64. Jimenez, Emmanuel, Vicente Paqueo, and Maria Lourdes de Vera. 1988. "Student Performance and Schools Costs in Private and Public High Schools in the Philippines." Policy, Planning, and Research Working Paper 61. World Bank, Population and Human Resources Department, Washington, D.C. Processed. Lee, Valerie, and Anthony Bryk. 1988. "Curriculum Tracking as Mediating the Social Distribu- tion of High School Achievement." Sociology of Education 61, no. 2: 78-94. Lee, Valerie, and Marlaine E. Lockheed. 1990. "The Effects of Single-Sex Schooling on Achieve- ment and Attitudes in Nigeria." Comparative Education Review 34, no. 2: 209-31. Luna, Eduardo, and S. Gonzalez. 1986. The Underdevelopment of Mathematics Achievement: Comparison of Public and Private Schools in the Dominican Republic. Santiago, Dominican Republic: Centro de Investigaciones UCMM. Murnane, Richard J. 1985. "Comparisons of Public ancl Private Schools: Lessons from the Uproar." Journal of Human Resources 20 (Spring): 263--67. Murnane, Richard J., Stuart Newstead, and Randall Olsen. 1985. "Comparing Public and Private Schools: The Puzzling Role of Selectivity Bias." Journal of Business and Economic Sta- tistics 3, no. 1: 23-35. Psacharopoulos, George. 1987. "Public versus Private Schools in Developing Countries: Evidence from Colombia and Tanzania." International Journal of Educational Development 7, no. 1: S9-67. Psacharopoulos, George, and William Loxley. 1985. Diversified Secondary Education and Devel- opment: Evidence from Colombia and Tanzania. New York: Oxford University Press. Robitaille, David E, and Robert A. Garden. 1989. The IEA Study of Mathematics II: Context and Outcomes of School Mathematics. Oxford: Pergamon Press. Roth, Gabriel. 1987. Private Provision of Public Services in Developing Countries. New York: Oxford University Press. Samoff, Joel. 1987. "School Expansion in Tanzania: Private Initiatives and Public Policy." Com- parative Education Review 31, no. 3: 333-60. Tsang, Mun, and Wimol Taoklam. 1990. "The Costs of Government and Private Primary Education in Thailand." Paper presented at the Comparative and International Education Society Annual Meetings, Anaheim, Calif., March. Willis, Robert J., and Sherwin Rosen. 1979. "Education and Self-Selection." Journal of Political Economy 87 (October supp.): S7-S36. World Bank. 1986. Financing Education in Developing Countries: An Exploration of Policy Options. Washington, D.C. 218 The World Bank Research Observer, vol. 6, no. 2 (July 1991) REFORM OF TRADE POLICY Recent Evidence from Theory and Practice Vinod Thomas John Nash In the 1980s many developing countries began to recognize that restrictive trade policies can constrain growth. To facilitate trade and integration into the world economy, many countries have embarked on reform programs. This survey synthesizes the conclusions of the literature on trade policy reform with those of a recent study by the World Bank analyzing reforms in developing countries, particularly those supported by adjustment lending programs. Its ob- jective is to shed light on some of the questions about these programs to guide policymakers in the future. The article reviews conditions in these countries before trade policy reforms were implemented and examines how much reform actually took place. It also examines the effects of the reforms on economic performance and reviews the factors that constrained the reform process. The survey considers the most important issues in designing and implementing trade policy reforms and concludes that although past reforms have had a pos- itive impact, future programs should emphasize three elements: reducing the level of protection, maintaining macroeconomic stability, and accounting for the conflicts and complementarities with other policies. T rade policy reform as discussed here covers measures that move the trade regime toward a more neutral incentive framework and a more liberal foreign trade regime. A neutral framework is one that does not discriminate between exportables and importables, between sales to domestic and export markets, or between tradables and nontradables. Liberal trade The World Bank Research Observer, vol. 6, no. 2 (July 1991), pp. 219-240 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 219 policies are those that reduce government controls and replace direct interven- tions (such as quantitative controls) with price mechanisms (such as tariffs). Expected Gains from Trade Policy Reform In the traditional literature on trade, the direct cost of distortions in resource flows caused by the misalignment of domestic and international prices is esti- mated to be a few percentage points or less of gross domestic product (GDP) a year. The costs are much larger, however, when the effects of trade restrictions on the structure of the market are also considered (Condon and de Melo 1986). Protection has the effect of encouraging firms to enter protected domestic mar- kets. Most of these firms will operate on an inefficiently small scale. The insu- lation of domestic producers from international competition has also been linked to oligopoly behavior in the domestic market. Caves (1980) and Jacquemin (1982) conclude that greater openness restricts oligopoly power. Bergsman (1974) estimates losses of 5 to 7 percent of GDP from oligopoly rents and inefficiencies associated with noncompetitive behavior in Pakistan and Brazil. Indirect costs include the waste of resources in income-generating but un- productive rent-seeking activities associated wilth protection-such as smug- gling, lobbying, and investing solely for the purpose of obtaining import licenses. The indirect costs of foreign exchange controls and nontariff barriers tend to be large because allocations are based on discretion rather than effi- ciency. These rent-seeking costs are estimated to amount to large fractions of GDP in such countries as India and Turkey (Grais, de Melo, and Urata 1986; Krueger 1974; and Mohammad and Whalley 1984). Reducing protection should raise GDP, but what explains the significant and sustained differences in rates of growth between restrictive, inward-oriented and liberal, outward-oriented economies? Cheniery, Robinson, and Syrquin (1986) provide evidence of a link between outward orientation and gains in productivity. Country studies have found productivity growth is significantly higher in periods of liberal trade policy-for example, Kim (1987) on Korea, Krueger and Tuncer (1982) on Turkey, and Nishimizu and Page (1982) and Havrylyshyn (1990) on Yugoslavia. Traditional growth theories are inadequate for cxplaining the relation between trade regimes and growth rates, but some recent approaches are more promising (for a discussion, see Edwards 1989a). Some new growth models have replaced the traditional assumption of constant returns to scale with one of increasing returns to scale. In other words, the unit cost of production declines as production rises. If the return to capital does not decline over time-it is assumed to decline in traditional models-the incentive to invest is retained. If trade policy reforms have this effect, they can generate a higher equilibrium growth rate. Other models have focused on the role of technological change: the more open the economy, the greater its ability to innovate and increase its long-term 220 The World Bank Research Observer, vol. 6, no. 2 (July 1991) rate of growth (Romer 1989). Other research has shown how greater trade openness increases incentives for research and development by widening the potential market and increasing the returns to such expenditures (Grossman and Helpman 1989). Pack (1988), however, argues that the higher growth of export-oriented economies is not a reflection of an increase in factor produc- tivity; in fact, the growth of factor productivity has not been conclusively linked to the trade regime. Rather, he concludes that growth is correlated with the ability of export-oriented economies to absorb the transfer of factors (such as labor) from sectors of low productivity to sectors of high productivity, with- out reducing the terms of trade in highly productive sectors (as would be the case if production were intended for limited domestic markets). Studies have also documented the effects of trade policy on income distribu- tion. In a sample of thirty-seven developing countries, Bourgignon and Morrisson (1989) conclude that protection was associated with an increase in inequality amounting to a drop of four to five percentage points in the share of income of the poorest 60 percent of the population and a 20 percent fall in the mean income of the poor. They point out that this result is consistent with predictions of the Stolper-Samuelson theorem: freer trade benefits the relatively abundant factor of production, which in developing countries is labor. Trade and domestic restrictions also have macroeconomic implications that are exposed when a country faces a severe external shock. Thus, for example, economies that maintained protectionist restrictions were largely divorced from the international price structure and failed to adjust to higher oil prices. Furthermore, these countries isolated their industries from technological progress abroad, undermining their competitiveness and restricting export opportunities. When the terms of trade shifted against them, many countries with restrictive and inflexible trade regimes were unable to increase exports rapidly and had little further scope for efficient import substitution. The results were large trade deficits and macroeconomic imbalances. Concerns about Reform Although earlier studies describe the benefits of trade policy reform (Krueger 1978; Michaely, Papageorgiou, and Choksi forthcoming), not everyone agrees that protection ought to be removed. Advocates of protection for infant indus- tries argue that costs diminish over time as industries become more efficient and competitive (see Grossiman 1989 for a review). Research on the subject is weak, principally because firm conclusions would require simulating what would have happened in the absence of infant industry policies. But experience suggests that infant industry arguments are generally used as a rationale by politically powerful interests seeking protection, without serious consideration of whether and under what conditions the economic benefits of protection will exceed the costs. Actual policies seldom recognize that if the initial economic costs are to be offset, the benefits must appear in a reasonably short period of time. Vinod Thomas and John Nash 221 World Bank studies have found that inefficient industries and firms received high protection for relatively long periods, while efficient-notably exporting- industries received relatively low protection. Moreover, in some cases, industri- al performance steadily deteriorated over prolonged periods of insulation from world markets as a result of protection policies. The problem seems to be that protected infant industries often fail to grow up. Some literature has developed theoretical support for protecting key indus- tries under certain conditions, based on the excess profits they are likely to earn in oligopolistic global markets (Spencer and Brander 1983; Krugman 1987a) or the external economies they create for other firms (Kemp and Negishi 1970; Panagariya 1980). But these interventions are hard to target successfully, and even these authors acknowledge that the conditions under which strategic trade policy can raise a country's welfare are unlikely to be met in practice, especially in developing countries (Krugman 1987b). (For a detailed account of an unsuc- cessful attempt to target protection for Brazil's aircraft industry, see Baldwin forthcoming.) Observers have also raised other concerns (for discussions, see Rodrik 1988; Sachs 1987; and Taylor 1988). Some assert that trade liberalization may aggra- vate the balance of payments and fiscal problems that afflict many developing countries. Others dispute the benefits of liberalization and greater openness, ar- guing that global trade restrictions, such as voluntary export restraints and the Multifibre Arrangement, will not allow reforming countries to increase exports. Some opponents of trade policy reform fear that liberalization will produce transitional unemployment and that devaluation will increase inflation. Others, who are not opposed to trade policy reform itself, question whether adjustment lending is an appropriate vehicle for promoting trade policy reform programs. Conflicts do arise between trade and other reforms, but the evidence suggests that proper sequencing of reforms can help minimize these conflicts. Trade pol- icy reforms generally improve economic performance when they are credibly implemented and accompanied by complementary actions. Although short- term transitional costs can be expected, the evidence from previous research (Michaely, Papageorgiou, and Choksi forthcoming) shows no clear relationship between trade liberalization and unemployment. Although in some cases un- employment rose in the period immediately following reform episodes, the study concluded that this increase usually resulted from other causes, such as the stabilization measures that were put in place to resolve macroeconomic crises. Implications of Reform Developing countries in general have very restrictive trade regimes. Erzan and others (1988) estimate that nontariff barriers cover 40 percent (unweighted) of all products in the Tariff Code, compared with about 15 percent in industrial 222 The World Bank Research Observer, vol. 6, no. 2 (July 1991) countries (Finger and Laird 1987). Average tariffs in developing countries were 34 percent, in industrial countries about 5 percent. The forty countries that re- ceived trade policy-related loans from the World Bank during 1980-87 fall into three broad categories of antiexport bias (low, medium, or high). Sixty percent of the countries had a high level of restrictions, 35 percent had a medium level, and only Chile and Korea had a relatively low level. Table 1 shows that reforms of export policies, exchange rates, and quanti- tative restrictions were generally stronger than those related to the level and dispersion of tariffs (Halevi 1989). Although data were available for only 24 recipients, evidence suggests that implementation of the reform proposals varied considerably. Some countries, such as Guyana, Yugoslavia, Zambia, and Zimbabwe, made little progress-or even backtracked-while others (Chile, Mexico, and Turkey) undertook substantial reforms. Progress has been made in correcting misaligned exchange rates (figure 1) and in reducing impediments to exports, including permitting imports needed by exporters. Several countries have substituted tariffs for quantitative restric- tions. Joint reductions of redundant protective policies, such as quantitative restrictions and tariffs, have been more modest. The growth of imports as a share of GDP is larger for the recipients of trade adjustment loans than for Table 1. Distribution and Intensity of Trade Reforms for Forty Countries, 1979-87 Not Intensity Area of reform Included included Strong Medium Weak Exchange rate flexibilitya 38 2 Export promotionb 33 7 Studiesc 28 12 Neutrality of export policy 15 15 10 Imports for exports 17 15 8 Overall import policy 14 15 11 Nonprotective quantitative restrictions 14 16 10 Protective quantitative restrictionsd 14 15 11 Tariff leveld 7 21 12 Tariff dispersion 7 24 9 Schedule of future action 6 29 5 Overall reduction in antiexport bias 17 12 11 a. Often these were not written conditions, but understandings, usually as part of a standby agreement. b. This includes removal of restrictions, provision of export credits, insurance, guarantees, institutional development, and the like. c. Studies on trade policy reforms. d. Where reforms replaced quantitative restrictions by tariffs, they are counted in both lines. Sometimes the changes reduced protection and sometimes not. Restrictions applied to products that compete with domestic production are protective; others are nonprotective. Source: World Bank data. Vinod Thomas and John Nash 223 Figure 1. Real Excbange Rate Indices: Extent of Devaluation for Selected Country Groups, 1978-88 (unweighted averages; 1980 = 100) Index 115 110 105 100 -- . ..... . .. 95 90 85 85 -_. - - _ Industrial countries 80 Recipients of trade adjustment loans - … - - - - Nonrecipients of trade adjustment loans 75- 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 Note: Data are based on a multilateral index of the real exchange rate measured against a basket of currencies of trading partners. An increase in the index indicates a real appreciation. Source: International Monetary Fund data. nonrecipients, which suggests the positive effects of increased financing and im- port liberalization. A number of domestic factors constrained reform efforts. In Kenya, Peru, Yugoslavia, and Zimbabwe, vested interests against reform and weak convic- tions about its benefits combined to undermine the commitment to reform (Bhagwati 1978; Krueger 1978; and Little, Scitovsky, and Scott 1970). Admin- istrative and institutional bottlenecks contributed to setbacks in implementa- tion in Bangladesh, Cote d'Ivoire, and Malawi, where reforms to strengthen public sector institutions received inadequate attention. Weak macroeconomic performance and conflicts between the goals of policy reform and stabilization slowed trade liberalization in Morocco and the Philippines and led to its rever- sal in Argentina and Zambia. And finally, the slow supply response, which has reduced the apparent benefits of reform, has undermined the enthusiasm of the low-income countries of Sub-Saharan Africa. Researchers have often found a positive association between exports and economic growth (Balassa 1982, 1986; World Bank 1987b), although the corre- 224 The World Bank Researcb Observer, vol. 6, no.2 (July 1991) lation is less clear in low-income countries (Kavoussi 1984; Ram 1985). Figure 2 shows the correlation between an increase in exports and GDP growth. Admit- tedly, exports are part of GDP, but this does not necessarily mean the correlation is a statistical artifact and a similar picture emerges if exports are excluded. This does not, however, prove causality. Tracing export growth to the influence of specific policies is complex because there are many potential causes for im- provement (Findlay 1984 and Jung and Marshall 1985 discuss some of the issues). Thomas and Nash (1991) report a correlation between trade adjust- ment lending and a mild improvement in GDP, exports, and other economic variables. They find that results are stronger and statistically more significant when the comparison is between trade policy reformers and nonreformers rather than between trade loan recipients and nonrecipients. The positive effects on exports and output are likely to be more immediate from a real devaluation and improved export policies than from a real devalu- ation and import liberalization (Lopez 1989). Harberger (1989) points to a close short-term link between devaluation and a rapid response in the balance of Figure 2. Growtb in GDP and Exports for Selected Developing Countries, 1965-88 (percent) a Exports growth rate 30 L Korea 0 20 Jordan 0 Botsa 0 Turkey/ 10 Brazil-6 0 Thailand Morocco hile0 China Oman Moroo Indonesia 0 Argentina n * . Pakistan 0 :/ hGhan °Syi 0 Uganda 0 Mozambique -10 -5 0 5 10 15 20 GDP growth rate b Note: LL is a fitted line based on least squares regression. Both solid and open dots represent individual countries. Because of overlap, only selected countries are labeled. a. Average growth rate of exports of goads and nonfactor services over the period. b. Average over the period. Source: World Bank data. Vinod Thomas and John Nash 225 trade. Longer-term increases in exports and output also depend on import liberalization. A 10 percent tariff is equivalent to a tax on exports of 4.3 to 9.5 percent (Clements and Sjaastad 1984; Greenaway and Milner 1987). Other empirical work also finds that import and export policy reforms had the same positive effect on growth of output. Heitger (1987) found that both the level and dispersion of effective protection rates had a negative effect on growth, while exports were positively correlated with growth rates. But the output gains from policy changes have not been as great as expected. Studies identify several factors that may have constrained the supply response. First, developing countries may not give enough attention to the institutional and infrastructural needs of exporters, such as port, transport, and telecommu- nications facilities, access to imported inputs, and information and marketing services. In addition, when entrepreneurial and managerial skills are relatively underdeveloped, the supply response is slow. Shortages of trained labor and poorly developed input supply lines are serious problems in many cases. Second, domestic regulatory and public sector policies influence the supply response by determining whether incentives actually change (in the case of price controls) and by affecting the mobility of factors of production in response to changes in incentives (labor regulations, regulations for entry to and exit from the market, controls on foreign investment). Some public sector policies have impeded rapid adjustment to a changed incentive structure and inhibited the supply response. These include allocation mechanisms in centrally planned economies and state monopolies of agricultural markets. Third, a rise in protection in international markets has depressed world prices and blocked access to markets, particularly for agricultural products. Industrial countries may be more promising markets for manufactured goods because of low tariffs, but nontariff barriers in some important product categories, in- cluding textiles, clothing, and steel, have hurt exports from developing countries. Finally, the response is influenced by the perception that the reforms will last. Expectations of failure and reversal become self-fulfilling prophecies. The government's credibility depends on its previous track record, the effectiveness of its first steps toward reform, the maintenance of economic stability, and the extent to which the program is consistent with other reforms (in the financial sector, for example). Trade Policy Measures Some economies have achieved a neutral incentive regime through a relative- ly hands-off strategy, but others have opted for selective government assistance. Thus relatively liberal, noninterventionist regimes in Chile and Hong Kong suc- cessfully promoted trade and growth, as did regimnes based on market interven- tion and government assistance, such as those in the Republic of Korea and Taiwan. In general, noninterventionist and neutral policies avoid the problems 226 The World Bank Research Observer, vol. 6, no. 2 (July 1991) of misjudgment and abuse that plague targeted investment policies (Agarwala 1983; Balassa 1988; Easterly and Wetzel 1989; Edwards 1989a; Landau 1983; Marsden 1983; and Scully 1988). Even in Korea, targeted assistance to specific industries between 1973 and 1979 contributed to an economic crisis (World Bank 1987a). The failure of this strategy influenced the government's decision to liberalize the trade regimne in the 1980s (Kim 1987). On average, less inter- ventionist policies have also been more effective in promoting exports and growth. They also help avoid the imposition of countervailing duties under the General Agreement on Tariffs and Trade (GATT). Exchange Rate Policy The real exchange rate should help ensure equilibrium in the balance of pay- ments and in domestic markets and should be compatible with growth in trad- ables and output. Edwards (1989b) considers some of the empirical issues associated with estimating an appropriate exchange rate. An overvalued currency indirectly taxes exportables and importables that are lightly protected while fa- voring nontradables and importables that are protected by binding nontariff re- strictions. Fluctuations in the real exchange rate have an adverse effect on exports because they create considerable uncertainty (Caballero and Corbo 1989). A real devaluation, accompanied by exchange rate unification where rele- vant, improves incentives for export industries and production of import sub- stitutes. Macroeconomic stability, with low fiscal deficits, low inflation, and stable exchange rates, has been the hallmark of East Asia's economic success. From 1970 to 1986, for example, Korea's real exchange rate deviated signifi- cantly (more than 14 percent) from its 1980 value during only two years (Bhattacharya and Linn 1988). In contrast, in C6te d'lvoire, whose currency is pegged at a fixed rate to the French franc, a reform program faltered in part because a manipulation of import tariffs and export subsidies, which was not fully implemented, proved to be a poor substitute for devaluation after the real exchange rate moved far out of line (O'Connell 1989). Export Policy As noted, Korea and Taiwan have been successful exporters despite protec- tive import policies (in the 1960s and 1970s) by avoiding an overvalued ex- change rate and by using export subsidies and other measures to offset import restrictions. This approach would be difficult to replicate, however, since it in- cluded vigorous government suppression of rent-seeking activities that were considered incompatible vvith export growth, implemented by methods that many governments would be unwilling or unable to use. In general, export subsidies-including income tax rebates, which have long been used in Latin America-have not had the desired effect. Not only are they Vinod Thomas and John Nash 227 subject to countervailing duties, but subsidies hiave resulted in cheating, ficti- tious claims of export production, and wasteful rent-seeking (World Bank 1986). Furthermore, subsidies may generate macroeconomic disequilibrium and an external debt problem, as Havrylyshyn (1990) found in Yugoslavia, or bur- den efficient export sectors, as Nogues (1989) found in Argentina. Policies that give special treatment to exporters have also been a problem in socialist countries. China's dramatic export growth may be less than meets the eye because a significant but unknown proportion of exports may reflect exces- sive incentives and a highly distorted price system (World Bank 1988a). Fitzgerald and Monson (1989), who investigated the export credit and insur- ance subsidy programs of seven developing countries, found no evidence that they were cost-effective. Far more effective were policies in East Asian countries that gave exporters and their suppliers access to inputs at duty- ancl tax-free international prices. Such measures eliminate wide variations in incentives among products that use inputs subject to different import controls and tariffs. Moreover, such measures are not subject to countervailing duties. Duty-free schemes impose costs, how- ever. They draw resources from often unprotected or taxed activities; they temporarily reduce government revenues; and they increase opportunities for rent-seeking. These costs need to be balanced against the likely economic gains. Efficient infrastructure, export credit, and schemes for quality control allow exporters of manufactures to be more competitive. Some countries have tried setting up export development (or free trade) zones to insulate exporters from inherent infrastructural or policy-based inadequacies. A comparison of success- ful East Asian exporters with other countries shows that such zones tend to be successful only where they are part of an overall favorable environment, as in Korea, rather than a substitute for such an environment, as in Malaysia, the Philippines, and Thailand (Linn and Wetzel 1990). Experience also suggests the value of adjusting restrictive regulations that affect strikes, layoffs, fringe ben- efits, and minimum wages. Technical assistance from consultants and foreign firms chosen by the exporters has been more effective than that provided by official export promotion organizations (Keesing and Singer 1989). Encourag- ing foreign investors by maintaining a stable economy, private property rights, a transparent regulatory environment, and liberal access to foreign exchange and imported inputs and services is also valuable (internal World Bank mem- orandum). Since foreign investment is a source of technology, capital, and con- nections to world markets, such policies are likely to be superior to special incentives, such as tax holidays, which may attract footloose industries that leave when the holiday is over. Other policies are needed to counteract the bias against primary exports. Trade in these products is frequently discouraged by overvaluation, taxes, and controlled prices. Often marketing is in the hands of inefficient government monopolies. In Argentina, for example, where agriculture provides about 75 percent of exports, antiexport policies keep exports at half their potential 228 The World Bank Research Observer, vol. 6, no. 2 (July 1991) level (Sturzenegger forthcoming). In the 1960s and 1970s, Malaysia and Chile improved the policy environment for primary exports, with good results. Reforms in Chile, based to a large extent on foreign private investment, rein- vigorated the export-oriented mining sector. These reforms also stimulated a spectacular increase in exports of agricultural and wood products, which climbed from US$44 million in 1972 to US$1.1 billion in 1986 (World Bank 1986; internal World Bank report).1 But reforms aimed at primary exports have been modest. Bolivia and Guinea opened mining to foreign investment. Bangladesh, Cote d'Ivoire, Ghana, Malawi, the Philippines, and Turkey improved producer prices for exports of primary products by eliminating direct or implicit taxes. Argentina and Uruguay reduced export taxes, although the tax was quickly reinstated in Argentina for revenue reasons. In Colombia, Mexico, Morocco, and Tanzania, a reduction of regulatory controls on exports helped primary products. Malaysia and Thailand achieved sustained growth in exports of primary com- modities by avoiding major currency overvaluation, heavy taxation, and high protection of manufacturing industries. Ghana, Madagascar, Mali, Morocco, Nigeria, Senegal, and Tanzania have eliminated public sector marketing boards or stripped them of their rnonopoly procurement powers. These boards, espe- cially in Africa, have almost always depressed producer prices and have rarely been effective in stabilizing prices (Knudsen and Nash 1990). Although governments have often kept producer prices of exports low in the belief that production and exports are not responsive to price, a number of studies refute this contention. Balassa (1986, 1988) found an exchange rate re- sponse for primary commodities almost as large as that for all merchandise (in- cluding primary) exports--and even larger for a sample of Sub-Saharan African countries. Similarly, Jaeger (1989) found a significant positive supply elasticity of export crops (and total value added in agriculture) to the producer price in a sample of Sub-Saharan African countries. This evidence, together with the presence of severe distortions that depress producer prices, confirms Binswanger's (1989) conclusion that policy reform can quickly increase exports of primary commodities from individual countries. Other obstacles, however, may not be in the control of developing countries. Exports of some key agricultural products that compete with products from temperate zones have been constrained by protection in industrial countries, while growth in the demand for and the prices of tropical products has also been low. Consequently, a significant growth in exports will also require export diversification (Koester, Schafer, and Valdes 1989). Import Policy Nontariff import barriers (import licensing, voluntary export restraints, exemptions, quotas, official reference prices, and foreign exchange allocations) make the structure of protection less transparent and the import system more Vinod Thomas and John Nash 229 uncertain. They sever the link between domestic and international prices, and they encourage lobbying, rent-seeking, and corruption. For these reasons, a re- duction in nontariff barriers, even if the level of protection remains roughly the same, can have important beneficial effects on the economy. One simple reform is to switch from a positive list of permitted imports, which creates high levels of uncertainty and strong lobbying pressures, to a negative list of prohibited imports that allows unrestricted entry of all unlisted items. Other barriers, such as quotas or licensing requirements, can also be reduced or phased out. Quotas can be auctioned, and the size of the quota increased until the auction bids (and their protective value) fall to zero, at which time imports can be freely allowed. Or a tariff could be imposed on imports above the quota ceiling. The level of the tariff could then be reduced over time. With the exception of Colombia, such schemes have been tried only in industrial countries, which tend to rely more on specific numerical quotas than on the discretionary licenses used in developing countries. A more common measure in developing countries is to impose tariffs providing approximately equivalent protection on product categories as nontariff controls are eliminated. This change reestablishes the link between domestic and international prices, ensuring that they move in the same direction and diverge by no more than the amount of the tariff. Tariffs are a more transparent form of protection and frequently have a revenue-raising function as well. But tariffs on finished products are usually higher than on intermediates and raw materials, and exemptions are common, causing effective protection to vary greatly across industries. One of the goals of reform is to reduce this dispersion to spur efficiency in the allocation of resources. A relatively low and uniform tariff structure is preferred on grounds of efficiency and political economy, even though it is impossible to predict with certainty that resource allocation will become rnore efficient (Bhagwati and Srinivasan 1973). Studies of optimal tariff structure (see, for example, Chambers 1989 and Panagariya 1989) are sensitive to the underlying assump- tions of the model and to the presumed objectives of the tariffs. But still, the general conclusion favors uniformity. Uniform protection also has the practical advantage of being less subject to lobbying and political influence. One quali- fication is that governments may need to supplement uniform tariffs with taxes on final consumer goods to minimize distortions in consumption. Another is that raising low tariff rates as a step toward unification encourages domestic production of these goods and might draw resources from exports and any "underprotected" import substitutes. For this reason, exporters would have to be insulated from paying prices above world levels for these protected inputs. Some of the more successful reformers (such as Bolivia, Chile, and Mexico) have converged their tariff structures tovvard 15 percent, nearly elim- inating quantitative restrictions, while others have reduced tariffs to less than 30 percent. 230 The World Bank Research Observer, vol. 6, no. 2 (July 1991) In most countries, increasing production efficiency requires reducing effec- tive protection and rationalizing the protection provided to imports, taking into account the protective effect of the domestic tax system (Rajaram 1989). For example, domestic tax rates in Ghana varied so much across sectors that a uni- form 30 percent tariff would result in effective protection rates ranging from zero to 50 percent (Shalizi and Squire 1986). In countries in which tariffs have an important revenue-raising role, coordinating tariff and tax reforms makes deep cuts in tariffs possible. The goal would be a low, equal tax on imports and domestic production, possibly administered as a tax on consumption. Reforming tariffs industry by industry is difficult, since changes in one in- dustry may have repercussions in others. A concertina strategy, in which the top rates are gradually collapsed to the next highest level, is preferable. A radial reduction, in which all rates at each step are cut to an equal fraction of their previous level, is even better (Harberger 1974). But a radial tariff reduction, while promising more rapid gains in production efficiency, is more likely to reduce revenues in the first stages than the concertina method. This latter scheme concentrates initial reductions on very high rates, at least some of which may be so high that reducing them will increase import volume enough to raise tariff revenues. Greater uniformity could best be achieved by a combi- nation of strategies: a collapse of very high rates and a radial reduction of all other rates. In countries where tariffs on inputs are much lower than those on final products (as is commonly the case), an increase in tariffs on inputs in- creases revenue and allows high rates to be reduced, while making effective protection more uniform (Harberger 1988). Designing and Sequencing Trade Policy Reforms and Complementary Policies In designing and sequencing reforms, it is important to consider whether trade liberalization and stabilization are incompatible and whether the fiscal deficit and inflation should be reduced before trade policy reform is introduced. To the extent that tariff reduction leads to revenue losses, liberalization can exacerbate the deficit and lead to inflation (see Fischer 1989; World Bank 1988b). Devaluation raises the price of tradables and can (in the short run, at least) increase inflation, while import liberalization can aggravate balance of payments problems. Another issue is whether trade policy reforms are effective under macroeco- nomic instability. Where inflation has been very high and variable, Fischer (1984) points out that leads and lags in the movement of individual prices have made resulting prices a poor guide for economic decisions. Furthermore, the exchange rate is often used instead of adequate macroeconomic policies as an anti-inflationary tool in such situations, thereby reducing the effectiveness of trade policy reform (Corbo and de Melo 1987; Kiguel and Liviatan 1988). Vinod Thomas and John Nash 231 Under these conditions, trade policy reform measures whose effectiveness depends on relative price changes are unlikely to be successful and should be delayed until inflation can be reduced. In other cases, however, experience corroborates Krueger's (1981) conclusion that trade policy reform and stabilization can proceed successfully in tandem. Whatever the potential conflicts, strong trade policy reformers have been more adept at reducing the fiscal deficit, bringing inflation down, and cutting the bal- ance of payments deficit than weaker reformers (table 2). One reason for this is that some reforms increase revenues and, as noted below, other fiscal instru- ments can be used to offset any decline in tariff revenues. Once the fiscal deficit is reduced, the current account deficit also tends to decline, and inflation falls even with a devaluation. Many trade policy reforms are not inconsistent with fiscal adjustment. Elim- inating nontariff barriers-especially converting them to tariffs-and eliminat- ing tariff exemptions can increase revenue. So can reducing very high tariffs, if evasion rates fall or if imports rise. But governments cannot count on such increases. Matin (1989) notes that for a sample of countries that rationalized nontariff barriers, tariff revenue increased from 2.7 percent of GDP to 3.4 percent. But for a sample of tariff Table 2. Macroeconomic Indicators before and after Trade Policy Reform in Twenty-Four Countries (unweighted average percentage) 3 years 2 years 1 year Year of 1 year 2 years 3 years Indicator before before before program after after after Inflation rate Strong reform 31.5 34.3 30.6 S.S 25.9 22.9 22.6 Medium reform 12.4 11.8 12.3 9.3 8.9 8.1 7.6 Weak reform 15.5 15.7 15.3 17.4 14.8 16.9 19.3 Fiscal balance-GDP ratio Strong reform -4.8 -6.4 -7.8 --7.2 -6.1 -4.4 -4.6 Medium reform -7.2 -7.8 -6.0 --5.8 -5.4 -5.1 -4.7 Weak reform -8.0 -6.8 -8.6 --8.9 -8.4 -8.0 -13.8 Resource balance-GDP ratio Strong reform - -5.2 -3.4 -2.5 --1.5 0.4 -0.7 -1.1 Medium reform -8.8 -8.6 -7.1 -6.4 -7.1 -6.0 4.4 Weak reform -6.2 -9.9 -7.5 -7.8 -6.4 -6.4 -3.2 Note: Data are for twenty-four countries for which data on implementation are available. The extent of reform for 1980-87 is based on a combination of changes in policies (strong, medium, or weak) with respect to devaluation of the exchange rate and commercial policy. Countries are grouped as follows: strong (strong in both categories or strong in one and medium in the other): Chile, Colombia, Ghana, Jamaica, Korea, Mauritius, Mexico, and Turkey; medium (medium and medium, or strong and weak): Bangladesh, Madagascar, Morocco, Pakistan, Panama, the Philippines, and Thailand; and weak (others): C6te d'lvoire, Guyana, Kenya, Malawi, Senegal, Togo, Yugoslavia, Zambia, and Zimbabwe. (Weak includes countries that reversed trade reforms.) Source: World Bank data. 232 The World Bank Research Observer, vol. 6, no. 2 (July 1991) reformers-among them Mexico, Morocco, the Philippines, and Thailand- revenue fell on average from 2.8 percent of GDP to 2.3 percent. How important this decline is depends on the share of trade taxes in the government's revenue base. As a percentage of total revenue, explicit trade taxes ranged from 4 per- cent in Brazil to 58 percent in the Gambia, averaging 36 percent in low-income and 19 percent in middle-income countries (World Bank 1988b). Implicit taxes-the difference between what state marketing boards pay producers for an exportable and the price at which they sell it-are sometimes more impor- tant than explicit taxes, as Schiller (1988) found in C6te d'Ivoire. Furthermore, the fiscal effects of devaluation depend on whether the government is a net buyer of foreign exchange or a net seller. Governments can combine a devalu- ation with tariff reform to prevent any decline in foreign currency revenue from being reflected in revenue denominated in domestic currency. Efforts to evaluate the likely revenue effects of specific trade policy reforms deserve more attention. Governments may need to reduce expenditures or increase revenues from other sources to avoid exacerbating the budget deficit. For example, Mexico generated additional revenue through tax reform when import liberalization lowered trade taxes. In contrast, Morocco did nothing to offset the revenue loss and subsequently reversed some policies. Shalizi and Squire (1986) point out that fiscal policy can also complement trade policy re- form by making tax rates on domestically produced final goods equal to tariff rates on their imports, thereby reducing protection, raising revenue, and allow- ing tariff rates to be reduced further, as in Malawi, Nigeria, and Togo. Fiscal policy can support trade policy reform by ensuring that public investment helps the reforms succeed. Public investment budgets have borne the brunt of expen- diture cuts in many countries, but investments in infrastructure, research and development, and extension services are important if exporters are to benefit from increased trade incentives. Infrastructural inadequacies create serious con- straints in low-income economies. For example, a World Bank (1989) study found that virtually all firms in Nigeria are hooked to (and pay for) the public power grid, yet every business with more than twenty employees relies on its own generator. In some African countries, fewer than 20 percent of all tele- phone calls and 10 percent of all international calls are completed. Trade Policy and Domestic Reforms External and domestic reforms are best carried out simultaneously because of their complementary effects (Pursell 1989). Hachette (1988) concluded that measures to eliminate labor regulations and allow firms to restructure or close down were important for the success of Chile's trade policy reforms. In Poland, Turkey, and Yugoslavia, however, regulations that make it costly for firms to restructure or shut down have been a factor in failed attempts at liberalization. An internal study by the World Bank supports the view that regulations gov- erning the entry of new firms and the expansion of established firms slowed Vinod Thomas and John Nash 233 the pace of adjustment in Mexico. Price or wage controls are incompatible with trade policy reforms whose purpose is to alter relative prices. In the face of rigid controls on labor, firms may have to fire ernployees or close down, even though the workers could have been employed at lower wages. Similarly, in- dustries trying to expand may be unable to bid labor away from sectors with high minimum wages. Financial sector regulations that encourage banks to continue to lend to bankrupt enterprises may dry up the supply of new credit to firms that should be expanding. Regulatory reform in these areas, combined with support for restructuring in the financial and industrial sectors, could magnify the benefits of trade policy reforms. But successful trade policy reformers have not waited until all complemen- tary domestic reforms and infrastructural investments were in place. In fact, trade policy reforms often expose the need to support new export industries whose development was difficult to foresee, so it makes sense to wait before making new investments in infrastructure. In some circumstances it is better to introduce external and domestic reforms in sequence. Otherwise economic agents might get the wrong signals. If investment or price controls are removed in highly protected sectors, for example, resources might be encouraged to flow to the wrong sectors. Conversely, removing export controls on products that are still heavily subsidized could cause the subsidy budget to balloon and prompt a run on domestic supplies as goods are sold into higher-priced world markets. Protection of state-owned manufacturing enterprises, or state-owned mar- keting channels for primary products, has interfered with liberalization programs in some countries (Nogues 1987). In socialist countries trade liberal- ization needs to be accompanied by the elimination of central planning and allocation mechanisms to allow market signals to be effective (Havrylyshyn 1989). A corrupt or inefficient customs service can also reduce the response of the trade sector. The Indonesian government transferred the entire staff of the cus- toms administration to other positions and contracted with a foreign firm for customs services (Barichello 1988). In many cases, administrative deficiencies have led to delays in introducing tariff reforms, export tax rebates, duty relief systems for exporters, and bonded warehouses. Sequencing and Pacing Reforms In countries with a substantially overvalued exchange rate, the first priority should go to a devaluation of the real exchange rate; countries with multiple exchange rates for tradables should unify them at this time. A large real deval- uation, which in effect increases the price of imports, can make quantitative import restrictions redundant and facilitate their rapid removal. This shift from outright protection to exchange rate protection is a major step toward a neutral trade regime. 234 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Corden (1987) and Michaely (1986) note that introducing export policy reforms before-or at the same time as-import reforms promotes a faster export supply response by allowing the unification of the tariff structure to pro- ceed without burdening exporters (as low tariffs on inputs are raised). One option is to replace nontariff barriers with tariffs providing roughly the same protection, while eliminating tariff exemptions. These measures ought to be followed by rationalizing and lowering tariff rates. If revenue is not a serious concern, however, nontariff barriers could be phased out without introducing equivalent tariffs. An expeditious reform program is preferable to a prolonged one because the benefits are greater and emerge sooner. And long, drawn-out adjustments give domestic firms time to organize, establish ties with officials carrying out the reforms, and lobby for reversal (Nelson 1989). Weak and indecisive reforms are especially prone to reversal (Colombia in the mid-1970s, Peru in the late 1970s). Two factors, however, argue against rapid reforms. First, in theory, unemploy- ment might be larger than when changes are phased in over time (although the evidence shows that labor has in fact been absorbed quite rapidly into expand- ing industries; see Michaely, Papageorgiou, and Choksi forthcoming). More- over, if a country's import regime is dominated by quantitative restrictions, a gradual liberalization of irnports could worsen temporary unemployment be- cause firms that might be able to expand would continue to face the delays and procurement problems typical of such regimes. A second argument concerns the credibility of the reforms and the likelihood that they will be sustained. Gradual reforms may be preferable if they are more likely to be accepted. In some countries a gradual approach may be politically more tractable. In practice, the optima] pace and intensity of import reform varies from country to country. Some successful reforms have been fast and comprehensive, as in Bolivia, where nontariff barriers were eliminated and a strong tariff re- form was advanced virtually overnight. In Korea, however, trade policy reforms were phased in over twenty years. Announcing trade policy reforms in advance helps the government's credibility and gives affected activities time to adjust. Whatever the individual circumstances, however, the experience of many strong reformers in the mid- to late 1980s is consistent with conclusions based on ear- lier periods: five to seven years from the initiation of reforms is sufficient for a substantial liberalization. This should allow time for quantitative restrictions to be phased out and for tariffs to be reduced to about 15 to 25 percent. Further tariff reductions could conme in later stages of reform. Conclusion Three broad conclusions can be drawn from this review of theoretical and empirical research on trade policies. First, although developing countries have Vinod Thomas and John Nash 235 more open and efficient trade regimes today than a decade ago, the progress of trade policy reform has been slower than anticipated under the reform pro- grams. Some developing countries have reduced quantitative restrictions, but much remains to be done in reducing nominal and effective protection levels. Second, where significant reforms have been credibly implemented along with other complementary reforms, the results in the external sector and in the econ- omy have been positive and sometimes spectacular. And third, the results have often fallen short of expectations. Macroeconomic instability and the absence of complementary policies and conditions have sometimes weakened the supply response. Three issues need particular attention. First, it: is important to reduce nom- inal and effective levels of protection, including lowering tariffs, to improve competitiveness. Second, for increased effectiveness, trade policy reforms should be supported by measures to maintain macroeconomic stability. Policy- makers may need to give more weight to the consequences of policy reforms on the fiscal deficit. And when the inflation rate is very high and variable, sta- bilization efforts should precede other reforms. Third, programs that pay attention to complementary policies, investments, and institutions are far more effective. Sometimes, internal distortions are so severe that they block the ben- efits from trade policy reform. These recommendations should improve the eco- nomic response to trade policy reforms and in so doing enhance their acceptability. Note Vinod Thomas is chief of the Trade Policy Division of the World Bank, and John Nash is senior economist in the same division. This paper is based on the authors' study, Best Practices in Trade Policy Reform (New York: Oxford University Press, 1991). The study contains contri- butions by Sebastian Edwards, Nadav Halevi, Thomas HIutcheson, Andras Inotai, Donald Keesing, Ramon Lopez, Kazi Matin, Garry Pursell, Alexander Yeats, and many others, under the overall guidance of Stanley Fischer and John A. Holsen. 1. One billion is 1,000 million. References The word "processed" describes informally reproduced works that may not be commonly available through libraries. Agarwala, Ramgopal. 1983. Price Distortions and Growth in Developing Countries. World Bank Staff Working Paper 575. Washington, D.C. Balassa, Bela. 1982. "Development Strategies and Economic Performance." In Bela Balassa, ed., Development Strategies in Semi-Industrialized Countries. London: Oxford University Press. . 1986. "Economic Incentives and Agricultural Exports in Developing Countries." Paper presented at the Eighth Congress of the International Economic Association, New Delhi. . 1988. "Incentive Policies and Agricultural Performance in Sub-Saharan Africa." 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"Exports and Economic Growth: Some Additional Evidence." Economic Development and Cultural Change 33: 415-25. Rodrik, Dani. 1988. "Liberalization, Sustainability, and the Design of Structural Adjustment Programs." World Bank, Country Economics Department, Washington, D.C. Processed. Romer, P. M. 1989. "What Determines the Rate of Growth and Technological Change?" PRE Working Paper 279. World Bank, Country Economics Department, Washington, D.C. Processed. Sachs, Jeffrey. 1987. "Trade and Exchange Rate Policies in Growth-Oriented Adjustment Pro- grams." Harvard University, Department of Economics, Cambridge, Mass. Processed. Schiller, C. 1988. The Fiscal Role of Price Stabilization Funds: The Case of C6te d'Ivoire. IMF Working Paper. Washington, D.C.: International Monetary Fund. Scully, G. W. 1988. "The Political Economy of Free Trade and Protectionism." Paper prepared for the Conference on the Political Economy of Neo-Mercantilism and Free Trade, Big Sky, Montana, June. Shalizi, Z., and Lyn Squire. 1986. "Tax Policy for Sub-Saharan Africa." World Bank, Country Policy Department, Washington, D.C. Processed. Spencer, B. J., and J. A. Brander. 1983. "International R&D Rivalry and Industrial Strategy." Review of Economic Studies 50: 707-22. Sturzenegger, Adolfo. Forthcoming. "Argentina." In A. 0. Krueger, M. Schiff, and A. Valdes, eds., The Political Economy of Agricultural Pricing Policy in Selected Latin American Coun- tries. Washington, D.C.: World Bank. Taylor, Lance. 1988. Economic Openness: Problems to the Century's End. Helsinki: World Institute for Development Economics Research. Thomas, Vinod, and John Nash. 1991. Best Practices in Trade Policy Reform. New York: Oxford University Press. World Bank. 1986. World Development Report 1986. New York: Oxford University Press. 1987a. Korea: Managing the Industrial Transition. 2 vols. Washington, D.C. . 1987b. World Development Report 1987. New York: Oxford University Press. 1988a. Adjustment Lending: An Evaluation of Ten Years of Experience. Policy and Research Series 1. Washington, D.C. 1988b. World Development Report 1988. New York: Oxford University Press. 1989. Sub-Saharan Africa: From Crisis to Sustainable Growth. Washington, D.C. 240 The World Bank Research Observer, vol. 6, no.2 (July 1991) WORLD BANK RESEARCH OBSERVER CUMULATIVE INDEX, 1986-1991 Authors Ahamed, Liaquat, "Stabilization Policies in Developing Countries," 1, no. 1 (January 1986): 79-110 Ahmad, Ehtisham, "Social Security and the Poor: Choices for Developing Countries," 6, no. 1 (January 1991): 105-27 Ayub, Mahmood A., and Sven 0. Hegstad, "Management of Public Industrial Enter- prises," 2, no. 1 (January 1987): 79-101 Bale, Malcolm D. (See Ulrich Koester), 5, no. 1 (January 1990): 95-121 Baumol, William J., and Kyu Sik Lee, "Contestable Markets, Trade, and Develop- ment," 6, no. 1 (January 1991): 1-17 Bell, Clive, "Reforming Property Rights in Land and Tenancy," 5, no. 2 (July 1990): 143-66 Bhagwati, Jagdish N., "Export-Promoting Trade Strategy: Issues and Evidence," 3, no. 1 (January 1988): 27-57 Binswanger, Hans, "Agricultural Mechanization: A Comparative Historical Perspec- tive," 1, no. 1 (January 1986): 27-56 Binswanger, Hans, and Prabhu Pingali, "Technological Priorities for Farming in Sub- Saharan Africa," 3, no. 1 (January 1988): 81-98 Binswanger, Hans P., and Joachim von Braun, "Technological Change and Commer- cialization in Agriculture: The Effect on the Poor," 6, no. 1 (January 1991): 57-80 Birdsall, Nancy, "Economic Analyses of Rapid Population Growth," 4, no. 1 (January 1989): 23-50 Carmichael, Jeffrey, "The Debt Crisis: Where Do We Stand after Seven Years?" 4, no. 2 (July 1989): 121-42 Corbo, Vittorio, and Jaime de Melo, "Lessons from the Southern Cone Policy Reforms," 2, no. 2 (July 1987): 111-42 Corden, W. Max, "Macroeconomic Adjustment in Developing Countries," 4, no. 1 (January 1989): 51-64 Corden, W. Max, "The Relevance for Developing Countries of Recent Developments in Macroeconomic Theory," 2, no. 2 (July 1987): 171-88 The World Bank Research Ohserver, vol. 6, no. 2 (July 1991), pp. 241-248 © 1991 The International Bank for Reconstruction and Development/THE WORLD BANK 241 Cox, Donald, and Emmanuel Jimenez, "Achieving Social Objectives through Private Transfers: A Review," 5, no. 2 (July 1990): 205-18 Cuddington, John, "Commodity Export Booms in Developing Countries," 4, no. 2 (July 1989): 143-65 de Melo, Jaime (See Vittorio Corbo), 2, no. 2 (July 1987): 111-42 Duncan, Ronald C. (See Donald 0. Mitchell), 2, no. 1 (January 1987): 3-21 Easterly, William (See Stanley Fischer), 5, no. 2 (July 1990): 127-42 Edwards, Sebastian, "Exchange Rate Misalignment in Developing Countries," 4, no. 1 (January 1989): 3-21 Eichengreen, Barry, and Richard Portes, "The Interwar Debt Crisis and Its Aftermath," 5, no. 1 (January 1990): 69-94 Elkan, Walter, "Entrepreneurs and Entrepreneurship in Africa," 3, no. 2 (July 1988): 171-88 Feder, Gershon (See Monika Huppi), 5, no. 2 (July 1990): 187-204 Feder, Gershon, and Raymond Noronha, "Land Rights Systems and Agricultural Development in Sub-Saharan Africa," 2, no. 2 (July 1987): 143-69 Feder, Gershon, and Roger Slade, "The Impact of Agricultural Extension: The Training and Visit System in India," 1, no. 2 (July 1986): 139-61 Fields, Gary S., "Changes in Poverty and Inequality in Developing Countries," 4, no. 2 (July 1989): 167-85 Findlay, Ronald (See Stanislaw Wellisz), 3, no. 1 (January 1988): 59-80 Fischer, Stanley, "Issues in Medium-Term Macroeconomic Adjustment," 1, no. 2 (July 1986): 163-82 Fischer, Stanley, and William Easterly, "The Economics of the Government Budget Constraint," 5, no. 2 (July 1990): 127-42 Fitzgerald, Bruce, and Terry Monson, "Preferential Credit and Insurance as Means to Promote Exports," 4, no. 1 (January 1989): 89-114 Goto, Junichi, "The Multifibre Arrangement and Its Effects on Developing Countries," 4, no. 2 (July 1989): 203-27 Greenaway, David, and Chris Milner, "South-South Trade: Theory, Evidence, and Policy," 5, no. 1 (January 1990): 47-68 Gross, David J. (See Stephen K. Mayo), 1, no. 2 (July 1986): 183-203 Havrylyshyn, Oli, "Trade Policy and Productivity Gains in Developing Countries: A Survey of the Literature," 5, no. 1 (January 1990): 1-24 Hegstad, Sven 0. (See Mahmood A. Ayub), 2, no. 1 (January 1987): 79-101 Huppi, Monika, and Gershon Feder, "The Role of Groups and Credit Cooperatives in Rural Lending," 5, no. 2 (July 1990): 187-204 242 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Jimenez, Emmanuel (See Donald Cox), 5, no. 2 (July 1990): 205-18 Jimenez, Emmanuel, "The Public Subsidization of Education and Health in Developing Countries: A Review of Equity and Efficiency," 1, no. 1 (January 1986): 111-29 Jimenez, Emmanuel, Marlaine E. Lockheed, and Vicente Paqueo, "The Relative Effi- ciency of Private and Public Schools in Developing Countries," 6, no. 2 (July 1991): 205-18 Kannappan, Subbiah, "Urban Labor Markets and Development," 3, no. 2 (July 1988): 189-206 Khan, Mohsin S., "Macroeconomic Adjustment in Developing Countries: A Policy Per- spective," 2, no. 1 (January 1987): 23-42 Koester, Ulrich, and Malcolm D. Bale, "The Common Agricultural Policy: A Review of Its Operation and Effects on Developing Countries," 5, no. 1 (January 1990): 95-121 Kravis, Irving B., "The Three Faces of the International Comparison Project," 1, no. 1 (January 1986): 3-26 Krueger, Anne O., "Aid in the Development Process," 1, no. 1 (January 1986): 57-78 Lal, Deepak, and Sarath Rajapatirana, "Foreign Trade Regimes and Economic Growth in Developing Countries," 2, no. 2 (July 1987): 189-217 Lee, Kyu Sik (See William J. Baumol), 6, no. 1 (January 1991): 1-17 Levin, Henry M., "A Benefit-Cost Analysis of Nutritional Programs for Anemia Reduction," 1, no. 2 (July 1986): 219-45 Lindauer, David L., Oey Astra Meesook, and Parita Suebsaeng, "Government Wage Policy in Africa: Some Findings and Policy Issues," 3, no. 1 (January 1988): 1-25 Lockheed, Marlaine E. (See Emmanuel Jitnenez), 6, no. 2 (July 1991): 205-18 Malpezzi, Stephen (See Stephen K. Mayo), 1, no. 2 (July 1986): 183-203 Markandya, Anil, and David W. Pearce, "Development, the Environment, and the Social Rate of Discount," 6, no. 2 (July 1991): 137-52 Mayo, Stephen K., Stephen Malpezzi, and David J. Gross, "Shelter Strategies for the Urban Poor in Developing Countries," 1, no. 2 (July 1986): 183-203 McCleary, William, "The Earmarking of Government Revenue: A Review of Some World Bank Experience," 6, no. 1 (January 1991): 81-104 McNelis, Paul D., "Indexation and Stabilization: Theory and Experience," 3, no. 2 (July 1988): 157-69 Meesook, Oey Astra (See David L. Lindauer), 3, no. 1 (January 1988): 1-25 Milner, Chris (See David Greenaway), 5, no. 1 (January 1990): 47-68 Mintz, Jack M., and Jesas Seade, "Cash Flow or Income? The Choice of Base for Com- pany Taxation," 6, no. 2 (July 1991): 177-90 Cumulative Index, 1986-1991 243 Mitchell, Donald O., and Ronald C. Duncan, "Market Behavior of Grains Exporters," 2, no. 1 (January 1987): 3-21 Monson, Terry (See Bruce Fitzgerald), 4, no. 1 (January 1989): 89-114 Mussa, Michael, "Macroeconomic Policy and Trade Liberalization: Some Guidelines," 2, no. 1 (January 1987): 61-77 Nash, John (See Vinod Thomas), 6, no. 2 (July 1991): 219-40 Nelson, Joan M., "Organized Labor, Politics, and Labor Market Flexibility in Devel- oping Countries," 6, no. 1 (January 1991): 37-56 Newbery, David M., "Charging for Roads," 3, no. 2 (July 1988): 119-38 Noronha, Raymond (See Gershon Feder), 2, no. 2 (July 1987): 143-69 Paqueo, Vicente (See Emmanuel Jimenez), 6, no. 2 (July 1991): 205-18 Pearce, David W. (See Anil Markandya), 6, no. 2 (July 1991): 137-52 Pingali, Prabhu (See Hans Binswanger), 3, no. 1 (January 1988): 81-98 Portes, Richard (See Barry Eichengreen), 5, no. 1 (January 1990): 69-94 Psacharopoulos, George, "Education and Development: A Review," 3, no. 1 (January 1988): 99-116 Psacharopoulos, George, and Zafiris Tzannatos, "Female Labor Force Participation: An International Perspective," 4, no. 2 (July 1989): 187-201 Rajapatirana, Sarath (See Deepak Lal), 2, no. 2 (July 1987): 189-217 Ravallion, Martin, "Reaching the Rural Poor through Public Employment: Arguments, Evidence, and Lessons from South Asia," 6, no. 2 (July 1991): 153-75 Seade, Jesus (See Jack M. Mintz), 6, no. 2 (July 1991): 177-90 Shoup, Carl, "The Value Added Tax and Developing Countries," 3, no. 2 (July 1988): 139-56 Slade, Roger (See Gershon Feder), 1, no. 2 (July 1986): 139-61 Solimano, Andres, "Inflation and the Costs of Stabilization: Historical and Recent Experiences and Policy Lessons," 5, no. 2 (July 19'90): 167-85 Srinivasan, T. N., "The Costs and Benefits of Being a Small, Remote, Island, Land- locked, or Ministate Economy," 1, no. 2 (July 1986): 205-18 Stiglitz, Joseph E., "Some Theoretical Aspects of Agricultural Policies," 2, no. 1 (January 1987): 43-60 Suebsaeng, Parita (See David L. Lindauer), 3, no. 1 (January 1988): 1-25 Takacs, Wendy E., "Options for Dismantling Trade Restrictions in Developing Coun- tries," 5, no. 1 (January 1990): 25-46 Thomas, Vinod, and John Nash, "Reform of Trade Policy: Recent Evidence from Theory and Practice," 6, no. 2 (July 1991): 219-40 244 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Tzannatos, Zafiris (See George Psacharopoulos), 4, no. 2 (July 1989): 187-201 von Braun, Joachim (See Hans P. Binswanger), 6, no. 1 (January 1991): 57-80 Wade, Robert, "The Management of Common Property Resources: Finding a Cooper- ative Solution," 2, no. 2 (July 1987): 219-34 Wakeman-Linn, John, "The Market for Developing Country Debt: The Nature and Importance of Its Shortcomings," 6, no. 2 (July 1991): 191-203 Warr, Peter G., "Export Processing Zones: The Economics of Enclave Manufacturing," 4, no. 1 (January 1989): 65--88 Wellisz, Stanislaw, and Ronald Findlay, "The State and the Invisible Hand," 3, no. 1 (January 1988): 59-80 Wood, Adrian, "How Much Does Trade with the South Affect Workers in the North?" 6, no. 1 (January 1991): 19--36 Titles "Achieving Social Objectives through Private Transfers: A Review," Donald Cox and Emmanuel Jimenez, 5, no. 2 (July 1990): 205-18 "Agricultural Mechanization: A Comparative Historical Perspective," Hans Binswanger, 1, no. 1 (January 1986): 27-56 "Aid in the Development Process," Anne 0. Krueger, 1, no. 1 (January 1986): 57-78 "A Benefit-Cost Analysis of Nutritional Programs for Anemia Reduction," Henry M. Levin, 1, no. 2 (July 1986): 219-45 "Cash Flow or Income? The Choice of Base for Company Taxation," Jack M. Mintz and Jesus Seade, 6, no. 2 (July 1991): 177-90 "Changes in Poverty and Inequality in Developing Countries," Gary S. Fields, 4, no. 2 (July 1989): 167-85 "Charging for Roads," David M. Newbery, 3, no. 2 (July 1988): 119-38 "Commodity Export Booms in Developing Countries," John Cuddington, 4, no. 2 (July 1989): 143-65 "The Common Agricultural Policy: A Review of Its Operation and Effects on Developing Countries," Ulrich Koester and Malcolm D. Bale, 5, no. 1 (January 1990): 95-121 "Contestable Markets, Trade, and Development," William J. Baumol and Kyu Sik Lee, 6, no. 1 (January 1991): 1--17 "The Costs and Benefits of Being a Small, Remote, Island, Landlocked, or Ministate Economy," T. N. Srinivasan, 1, no. 2 (July 1986): 205-18 "The Debt Crisis: Where Do We Stand after Seven Years?" Jeffrey Carmichael, 4, no. 2 (July 1989): 121-42 Cumulative Index, 1986-1991 245 "Development, the Environment, and the Social Rate of Discount," Anil Markandya and David W. Pearce, 6, no. 2 (July 1991): 137-52 "The Earmarking of Government Revenue: A Review of Some World Bank Experi- ence," William McCleary, 6, no. 1 (January 1991): 81-104 "Economic Analyses of Rapid Population Growth," Nancy Birdsall, 4, no. 1 (January 1989): 23-50 "The Economics of the Government Budget Constraint," Stanley Fischer and William Easterly, 5, no. 2 (July 1990): 127-42 "Education and Development: A Review," George Psacharopoulos, 3, no. 1 (January 1988): 99-116 "Entrepreneurs and Entrepreneurship in Africa," Walter Elkan, 3, no. 2 (July 1988): 171-88 "Exchange Rate Misalignment in Developing Countries," Sebastian Edwards, 4, no. 1 (January 1989): 3-21 "Export Processing Zones: The Economics of Enclave Manufacturing," Peter G. Warr, 4, no. 1 (January 1989): 65-88 "Export-Promoting Trade Strategy: Issues and Evidence," Jagdish N. Bhagwati, 3, no. 1 (January 1988): 27-57 "Female Labor Force Participation: An International Perspective," George Psacharopoulos and Zafiris Tzannatos, 4, no. 2 (July 1989): 187-201 "Foreign Trade Regimes and Economic Growth in Developing Countries," Deepak Lal and Sarath Rajapatirana, 2, no. 2 (July 1987): 189--217 "Government Wage Policy in Africa: Some Findings and Policy Issues," David L. Lindauer, Oey Astra Meesook, and Parita Suebsaerig, 3, no. 1 (January 1988): 1-25 "How Much Does Trade with the South Affect Workers in the North?" Adrian Wood, 6, no. 1 (January 1991): 19-36 "The Impact of Agricultural Extension: The Training and Visit System in India," Gershon Feder and Roger Slade, 1, no. 2 (July 1986): 139-61 "Indexation and Stabilization: Theory and Experience," Paul D. McNelis, 3, no. 2 (July 1988): 157-69 "Inflation and the Costs of Stabilization: Historical and Recent Experiences and Policy Lessons," Andres Solimano, 5, no. 2 (July 1990): 167-85 "The Interwar Debt Crisis and Its Aftermath," Barry Eichengreen and Richard Portes, 5, no. 1 (January 1990): 69-94 "Issues in Medium-Term Macroeconomic Adjustment," Stanley Fischer, 1, no. 2 (July 1986): 163-82 "Land Rights Systems and Agricultural Development in Sub-Saharan Africa," Gershon Feder and Raymond Noronha, 2, no. 2 (July 1987): 143-69 246 The World Bank Research Observer, vol. 6, no. 2 (July 1991) "Lessons from the Southern Cone Policy Reforms," Vittorio Corbo and Jaime de Melo, 2, no. 2 (July 1987): 111-42 "Macroeconomic Adjustment in Developing Countries," W. Max Corden, 4, no. 1 (January 1989): 51-64 "Macroeconomic Adjustment in Developing Countries: A Policy Perspective," Mohsin S. Khan, 2, no. I (January 1987): 23-42 "Macroeconomic Policy and Trade Liberalization: Some Guidelines," Michael Mussa, 2, no. 1 (January 1987): 61-77 "The Management of Common Property Resources: Finding a Cooperative Solution," Robert Wade, 2, no. 2 (July 1987): 219-34 "Management of Public Industrial Enterprises," Mahmood A. Ayub and Sven 0. Hegstad, 2, no. 1 (January 1987): 79-101 "Market Behavior of Grains Exporters," Donald 0. Mitchell and Ronald C. Duncan, 2, no. 1 (January 1987): 3-21 "The Market for Developing Country Debt: The Nature and Importance of Its Short- comings," John Wakeman-Linn, 6, no. 2 (July 1991): 191-203 "The Multifibre Arrangement and Its Effects on Developing Countries," Junichi Goto, 4, no. 2 (July 1989): 203-27 "Options for Dismantling Trade Restrictions in Developing Countries," Wendy E. Takacs, 5, no. 1 (January 1990): 25-46 "Organized Labor, Politics, and Labor Market Flexibility in Developing Countries," Joan M. Nelson, 6, no. 1 (January 1991): 37-56 "Preferential Credit and Insurance as Means to Promote Exports," Bruce Fitzgerald and Terry Monson, 4, no. 1 (January 1989): 89-114 "The Public Subsidization of Education and Health in Developing Countries: A Review of Equity and Efficiency," Emmanuel Jimenez, 1, no. 1 (January 1986): 111-29 "Reaching the Rural Poor through Public Employment: Arguments, Evidence, and Lessons from South Asia," Martin Ravallion, 6, no. 2 (July 1991): 153-75 "Reform of Trade Policy: Recent Evidence from Theory and Practice," Vinod Thomas and John Nash, 6, no. 2 (July 1991): 219-40 "Reforming Property Rights in Land and Tenancy," Clive Bell, 5, no. 2 (July 1990): 143-66 "The Relative Efficiency of Private and Public Schools in Developing Countries," Emmanuel Jimenez, Marlaine E. Lockheed, and Vicente Paqueo, 6, no. 2 (July 1991): 205-18 "The Relevance for Developing Countries of Recent Developments in Macroeconomic Theory," W. Max Corden, 2, no. 2 (July 1987): 171-88 "The Role of Groups and Credit Cooperatives in Rural Lending," Monika Huppi and Gershon Feder, 5, no. 2 (July 1990): 187-204 Cumulative Index, 1986-1991 247 "Shelter Strategies for the Urban Poor in Developing Countries," Stephen K. Mayo, Stephen Malpezzi, and David J. Gross, 1, no. 2 (July 1986): 183-203 "Social Security and the Poor: Choices for Developing Countries," Ehtisham Ahmad, 6, no. 1 (January 1991): 105-27 "Some Theoretical Aspects of Agricultural Policies," Joseph E. Stiglitz, 2, no. 1 (January 1987): 43-60 "South-South Trade: Theory, Evidence, and Policy," David Greenaway and Chris Milner, 5, no. 1 (January 1990): 47-68 "Stabilization Policies in Developing Countries," Liaquat Ahamed, 1, no. 1 (January 1986): 79-110 "The State and the Invisible Hand," Stanislaw Wel]isz and Ronald Findlay, 3, no. 1 (January 1988): 59-80 "Technological Change and Commercialization in Agriculture: The Effect on the Poor," Hans P. Binswanger and Joachim von Braun, 6, no. 1 (January 1991): 57-80 "Technological Priorities for Farming in Sub-Saharan Africa," Hans Binswanger and Prabhu Pingali, 3, no. 1 (January 1988): 81-98 "The Three Faces of the International Comparison Project," Irving B. Kravis, 1, no. 1 (January 1986): 3-26 "Trade Policy and Productivity Gains in Developing Countries: A Survey of the Liter- ature," Oli Havrylyshyn, 5, no. 1 (January 1990): 1-24 "Urban Labor Markets and Development," Subbiah Kannappan, 3, no. 2 (July 1988): 189-206 "The Value Added Tax and Developing Countries," Carl Shoup, 3, no. 2 (July 1988): 139-56 248 The World Bank Research Observer, vol. 6, no. 2 (July 1991) Available July 8 Reserve Your Copy Now World Development Report 1991 The Challenge of Development Featuring.. * The broadest examination of development ever presented by the Bank, based on a systematic review of development efforts over the 47 years since the Bretton Woods agreement. * World Development Indicators-the most compre- hensive and current data available on social and economic development in more than 120 countries. * A concise review of recent trends in the world economy. 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Cassen Director, International Development Centre, University of Oxford World Debt Tables 1990-9 1 * Features complete and up-to-date data on debt for more than 100 developing countries * Includes the latest 1989 data and projections through 1999 * Periodic supplements are sent throughout the year as new data become available When you need current and reliable data on developing country debt, you will not find a better source than World Debt Tables 1990-91. This new edition gives you instant access to data gathered through the World Bank's exclusive Debtor Reporting System. You also get an analysis of the world debt situation-from top World Bank economists-that puts the data in perspective. World Debt Tables 1990-91 Volume 1. Analysis and Summary Tables Volume 2. Country Tables Complete two-volume set and supplements 664 pages / ISBN 0-8213-1725-3 /US$125.00 / Order Stock #11725 Available separately Volume 1. 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