TCS Daily

World Bank, No Thanks

By Ana Isabel Eiras - May 11, 2004 12:00 AM

The Montenegrin parliament is ready to approve a package of free-market reforms designed to improve the investment environment and encourage small and medium "informal" businesses to enter the formal market. The package includes a reduction of employers' payroll taxes and contributions to pension and health care.

But there's something holding back action on the bill. No, it's not local interests or politics. It's the World Bank. Narrowly focused on how the tax cut might affect government deficits, the World Bank is threatening to withhold three loans if the parliament enacts the reforms without its prior approval.

Countries like Montenegro would have far better prospects of improving economic freedom and growth without the International Financial Institutions (IFIs) standing in their way.

Since 2003, the government of Montenegro has been shaping a bold, pro-business reform package. The main component is a 20 percent reduction in employers' payroll taxes and contributions to workers' pensions and health care. These reductions would be implemented in two phases: 10 percent retroactive to April 1, 2004, and the other 10 percent on September 1, 2004. The reductions aim to spur investment and greater business participation in the formal economy. The Montenegrin government believes that these rate cuts will broaden the tax base and collect more tax revenue.

The World Bank disagrees with the approach, arguing that:

  • It's too late in the fiscal year to change the budget plan;
  • The reductions are too steep, and
  • They will cause revenue to fall, contributing to a budget deficit.

The World Bank distrusts the government's dynamic budget projections (i.e., that tax revenues will increase by broadening the tax base) and refuses to give its "blessing" to the plan until it makes its own projections. Meanwhile, reform is stalled.

Now, cutting taxes may or may not generate a deficit in the short term. Broadening the tax base will offset part, if not all, of the initial drop in tax revenue. But even if a short-term deficit might result, that prospect does not merit such coercion by the World Bank.

Montenegro is imitating the success of countries such as Ireland, Estonia, and Russia in slashing their top tax rates. It is trying to provide opportunities for small, medium, and large enterprises to stay in business, invest more, create jobs, and contribute to higher growth rates while attracting informal businesses to the tax rolls.

And what's the alternative? Without the tax cuts, economic opportunity in Montenegro is severely limited. By limiting economic opportunity, the World Bank's misguided policy would keep Montenegro mostly poor. If the World Bank's coercion becomes too onerous, Montenegrins would be better off to forgo World Bank loans and implement their own reform package.

The World Bank's attitude toward the Montenegrin initiative brings up an important, often overlooked point in developing economics: reform sustainability. Only reforms originating from inside a country-are sustained. Conditions and mandates imposed by the World Bank and other outside institutions are rarely met or sustained. If the World Bank is really concerned about poverty in Montenegro, it should support the government's initiative to reduce taxes instead of imposing its own thoughts of what may or may not work in the country.

The World Bank now stands as an impediment to economic opportunity in Montenegro and other poor countries. It consistently fails to provide the developing world with incentives to move toward economic freedom.

To remedy this appalling situation, the United States should build on the work of the International Financial Institutions Advisory Committee (IFIAC) to establish a solid framework for reforming the World Bank's lending practices. The IFIAC advocates a new system of performance-based grants for the World Bank's social programs, with institutional preconditions that countries must meet to qualify for a loan. These include sound fiscal policy, freedom of entry and operation for foreign financial institutions, and adequately capitalized commercial banks. Dependence on foreign loans and economic instability around the world will decline only in an environment that promotes the efficiencies and benefits of open markets.

The United States also should support the Montenegrin government's efforts to advance pro-market reforms and use these efforts as examples for other poor economies. Poor countries have a far better chance of raising the living standards of their people by opening markets and creating opportunity than by following the mandates of international institutions.

Ana Isabel Eiras is Senior Policy Analyst for International Economics in the Center for International Trade and Economics at The Heritage Foundation.


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