International Debt Forgiveness: Who Gets Picked and Its Effect On The Tax Effort Of Developing Countries

We explore whether the expectation of debt forgiveness discourages developing countries from attaining sustainable fiscal independence through improving their tax effort. While the international financial community advises poor countries to improve revenue mobilization, the same international community routinely bail-out poor countries that fail to meet their loan repayment obligations. The act of bailing-out creates an expectation about receiving debt forgiveness time and again in the future. The key prediction of our theoretical framework is that in the presence of debt forgiveness, countries’ tax efforts will decline and more so the higher the intensity of the bailouts. We test this using data for 66 countries from 1989 to 2008. We find that debt forgiveness is significant in lowering tax effort. In addressing potential endogeneity issues we also find that the international financial community has been more forgiving to countries that exert lower tax effort. The results are robust to various specifications.