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that rich and influential taxpayers can prevent tax reform that affect them adversely. Property owners and the upper classes often successfully oppose a progressive income tax or sizable property tax, introduce tax loopholes beneficial to them, or evade tax payments without penalty.

The United States has a reputation for less legal tax avoidance and illegal evasion than most of the third world. However, a Brookings Institution study indicates that, even in the United States, taxes as a percentage of income remain nearly constant for virtually all income levels because of tax loopholes and the effect of indirect taxes. Furthermore, the U.S. Internal Revenue Service (IRS) assumes that the average U.S. citizen is rather resistant to taxation. Tax evasion is low because of the high probability and serious consequences of being caught (Pechman and Okner 1974; Tanzi 1975:234–236).

Tax collection in an LDC depends not only on the appropriate tax legislation, but also, more important, on administrative capability and political will. A noted tax authority wrote that

In many underdeveloped countries the low revenue yield of taxation can only be attributed to the fact that the tax provisions are not properly enforced, either on account of the inability of the administration to cope with them, or on account of straightforward corruption. No system of tax laws, however carefully conceived, is proof against collusion between the tax administrators and the taxpayers; an efficient administration consisting of persons of high integrity is usually the most important requirement for obtaining maximum revenue, and exploiting fully the taxation potential of a country. (Kaldor 1963:23)

Expenditure Policy

Many Afro–Asian leaders after independence were convinced that colonialism meant slow economic growth, largely as the result of laissez-faire capitalism (implying a minimum of government interference into the economy). These leaders focused populist and anti-imperialist sentiments in these countries into an ideology of African or Asian socialism. This socialism, frequently misunderstood by outsiders, usually did not imply that government was to own a majority of land and capital. Nor did it mean that tax revenue was a large proportion of GNP. As we indicated earlier, Wagner’s law of demand and administrative limits on tax collections restricted the social goods sector in most of these economies.

What socialism in the third world often meant was systematic planning (see Chapter 18) by the state to assure a minimum economic welfare for all its citizens. Yet World Bank statistics indicate that LDC governments spend a relatively small percentage of GNP on health, welfare, social security, and housing (in low-income countries, the 1992 expenditures on these categories were 1.2 percent of GNP and 6.7 percent of the central government budget; in middle-income countries, 5.8 percent of GNP and 24.5 percent of the budget; and in high-income countries, 15.6 percent of GNP and 49.6 percent of the budget), and a relatively large share on education, electricity,

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gas, water, transport, communication, and training programs (Table 14-3). For some middle-income countries such as Brazil, civil-service benefits have been excessive, requiring a trimming of the pensions of public-sector workers to contain debt (Economist, December 20, 2003, p. 48).

Doubtless in countries where a large part of the population is poor, welfare and social security payments to bring everyone above the poverty line not only would undermine work incentives but also would be prohibitively expensive (see Chapter 6). Moreover, as we have said earlier, infrastructure and education are important investments creating external economies in early stages of development (Musgrave and Musgrave 1980:813).

Military expenditures have a high foregone cost in resources for social programs in LDCs. In 1990–92, low-income countries spent 2.4 percent of GDP on defense (Ethiopia 12.4 percent and Mozambique, then fighting rebels supported by whiteruled South African–supported rebels, 11.9 percent6), an amount in excess of spending for health, education, housing, welfare, amenities, and social security. Lowincome countries spent 10.4 percent of import expenditures on armaments, and have 40 percent more armed forces (generally with above-average education) than teachers (U.N. Development Program 1994:47–60, 170–171).

Can government vary spending to regulate income, employment, and prices? Sound investment projects in education, power, transport, and communication are difficult to prepare and require a long lead time. Furthermore, as indicated, macroeconomic variables are not so sensitive to demand management in LDCs as in DCs. Spending policy, just as monetary and tax policies, is a limited instrument for influencing economic growth and price stability.

Inflation

ACCELERATED LDC INFLATION FROM THE 1970S TO THE EARLY 1990S

Inflation is the rate of increase in the general level of prices, measured by the consumer price index (CPI), the average price of a basket of goods and services consumed by a representative household, or by the GDP deflator, which compares the average price of the GDP basket today and in a base period. During the 1950s and the 1960s, economists considered inflation as a phenomenon affecting individual countries in isolation. To be sure, inflation in Latin America was 22 percent per year from 1960 to 1970. But if we exclude the 41 percent annual inflation rate of the contiguous region of Brazil–Uruguay–Argentina–Chile, Latin America’s annual rate for the decade was only 5 percent, comparable to that of Afro–Asia, that is, 6 percent (see Table 14-4). However, LDC annual inflation accelerated through the early 1990s, increasing from 9 percent in the 1960s to 26 percent in the 1970s and to 76 percent from 1980 to 1992,

6 The Economic Commission for Africa (1989) estimates that the nine Southern African Development Coordination Conference (SADCC) states – Angola, Botswana, Lesotho, Malawi, Mozambique, Tanzania, Swaziland, Zambia, and Zimbabwe – lost $60 billion (or one-fourth) of their gross domestic product from South Africa’s destabilization.

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before falling to 16 percent from 1992 to 2003, perhaps because of increased competition from globalization. Most of the increase came from rapid inflation in Latin America, 47 percent annually in the 1970s and 230 percent from 1980 to 1992! The DC inflation rates, while increasing from 4 percent in the 1960s to 9 percent in the 1970s, fell to 4 percent from 1980 to 1992 and 2 percent from 1992 to 2003.

Instability in the international economy during most of the 1970s exacerbated inflation. In 1971, the post–1945 Bretton Woods system of fixed exchange rates broke down. It was replaced by a floating exchange rate system, under which DCs experienced large swings in exchange rates. H. Johannes Witteveen, when president of the International Monetary Fund in 1975, argued that exchange fluctuations in an imperfectly competitive world exacerbated inflation by increasing prices in countries with a depreciating currency but not decreasing prices in countries with an appreciating currency. Poor world harvests in 1972 to 1973 increased food prices, wage rates, and cost–push inflation substantially in 1972 to 1974. Higher oil prices also pushed up costs and prices, especially in industry and power, in 1973 to 1975. Worldwide inflation remained high between 1975 and 1978, a period when, according to a Brookings Institution study, the effect of oil prices was not important. Inflation in the DCs radiated out to the LDCs through trade links (Witteveen 1975:108–14; Cline and Associates 1981; U.N. Department of International Economic and Social Affairs 1981:37–39). Yet, from 1978 through the end of the 1980s (as in the 1960s), inflation rates varied too widely among LDCs (note the differences between Latin America and Afro–Asia in Table 14-4) to attribute to a common cause. We cannot blame Paraguay’s rapid inflation in the early 1950s; Brazil’s, Uruguay’s, Chile’s, and Bolivia’s in the decade before 1974; or Brazil’s, Argentina’s, Peru’s, Bolivia’s, and Israel’s inflations in the 1980s and early 1990s at more than 100 percent yearly on international instability. Let us examine several causes in the following sections.

DEMAND–PULL INFLATION

The next seven sections consider the (1) demand–pull, (2) cost–push, (3) ratchet,

(4)structural, (5) expectational, (6) political, and (7) monetary explanations for inflation, and what government can do to reduce them.

Demand–pull inflation results from consumer, business, and government demand for goods and services in excess of an economy’s capacity to produce. The International Monetary Fund, when financing the international payments deficit for a rapidly inflating LDC, requires contractionary monetary and fiscal policies – reduced government spending, increased taxes, a decreased money supply, and a higher interest rate – to curb demand. Sometimes these demand restrictions do not moderate inflation. The LDC government may have to decrease substantially the employment rate and real growth to reduce the inflation rate. As a result, many LDC economists question the importance of demand–pull inflation and look for other causes of inflation.

Note: China is not included in 1960–70 for developing countries, Afro-Asia, and Asia. In 1960–2003, developing countries include developing Europe. Central Asia from the former Soviet Union is included among developing countries but not Afro-Asia in 1980–2003. The Middle East (with Turkey) is included in the Afro-Asian total.

a GNP deflator.

Sources: World Bank 1981i:134–35, 181; World Bank 1988i:222–23; World Bank 1994i:162– 63; IMF 2001d:72; IMF 2002d:178–185.

COST–PUSH INFLATION

The presence of cost–push and structural (supply-side) inflationary pressures may explain why a contraction in demand may cause unemployment and recession rather than reduce inflation. Cost–push inflation means prices increase even when demand drops or remains constant, because of higher costs in imperfectly competitive markets.

Labor unions may force up wages although there is excess labor supply – particularly by applying political pressure on government, the major employer and wagesetter in the modern sector. Higher food prices also may come into play, as during the poor worldwide harvests in 1972 to 1973. If food costs more, workers may press for higher wages.

Similarly, large businesses may increase prices in response to increased wage and other costs, even though demand for their products does not increase. Because of labor’s and business’s market power, economists sometimes label cost–push inflation “administered price” or “seller’s” inflation.

Economists may blame rising costs from demand–pull on cost push. Increased aggregate demand for finished goods and services expands business’s derived demand for raw materials and labor. When their short-run supply is inelastic, costs go up before finished-good prices rise. Despite appearances, here excess demand, not cost, is inflation’s cause (Fry 1988:330–331).

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RATCHET INFLATION

A ratchet wrench only goes forward, not backward. Analogously prices may rise but not go down. Assume aggregate demand remains constant but demand increases in the first sector and decreases in the second. With ratchet inflation, prices rise in the first sector, remain the same in the second, and increase overall.

The LDC governments could use antimonopoly measures and wage and price controls to moderate cost–push and ratchet inflationary pressures. Yet they may lack the political and administrative strength to attack monopolies and restrain wages. Several LDCs have instituted price controls but usually with mixed results. Price controls should be limited to highly imperfect markets, rather than competitive markets, where these controls cause shortages, long lines, and black markets. In addition, some business firms circumvent price controls by reducing quality, service, or in some instances quantity (for example, the number of nuts in a candy bar). Most LDC governments lack the administrative machinery and research capability to obtain the essential data, undertake the appropriate analysis, change price ceilings in response to movements in supply and demand in thousands of markets, and enforce controls.

STRUCTURAL INFLATION: THE CASE OF LATIN AMERICA

Some Latin American economists, especially from the U.N. Economic Commission for Latin America (ECLA), criticize the orthodox prescriptions of the International Monetary Fund for attaining macroeconomic and external equilibrium (see Chapters 16, 17, and 19). These economists also argue that structural rigidities, not demand–pull, cost–push, or ratchet inflation, cause rapid inflation in Latin America. Structural factors include the slow and unstable growth of foreign currency earnings (from exports) and the inelastic supply of agricultural goods. A price rise from these factors is termed structural inflation.

Sluggish growth in foreign exchange earnings relative to import demand occurs because a disproportional share of exports in Latin America are primary products (food, raw materials, minerals, and organic oils and fats) other than fuels (see Chapter 4). The slow growth in demand for these primary exports decreases the country’s terms of trade, that is, the ratio of its export prices to its import prices. Government restricts imports to adjust to foreign exchange shortages. Import demand, which grows with national income, exceeds import supply, and inflation sets in. Even expanding the supply of import substitutes (domestic production replacing imports) increases prices and input costs above import prices. The slow growth of export income necessitates frequent exchange-rate devaluation, which increases import prices. In addition export sluggishness keeps export tax revenues down, reducing government saving and further increasing inflation.

Food output is especially unresponsive to price rises – a second structural rigidity in LDC economies. This supply inelasticity is largely a result of defective land tenure patterns, such as concentrated land ownership, poor production incentives, and insecure tenancy.

All of these factors – deterioration in terms of trade, cost of import substitution, devaluation, and rise in agricultural prices – initiate cost–push inflation. Structuralists,

many of whom support the financially repressive policies discussed below, contend that contractionary monetary and fiscal policies, such as those advised by the International Monetary Fund, depress the economy and exacerbate political discontent without going to the heart of the problem, the need for fundamental structural change – land reform, expanding the industrial sector, antimonopoly measures, and improved income distribution (much of this section’s analysis is based on de Oliveira Campos [1964:129–137]).

Critics of the structuralists argue that the pressure on food supplies is not peculiar to Latin America. In fact, the United Nations and the U.S. Department of Agriculture indicate both total and per-capita food production grew about as rapidly in Latin America in the 1970s and 1980s as in any other region of the developing world (Figure 7-1 and U.N. Department of International Economic and Social Affairs 1981:28).

In addition, Latin American export growth has not been sluggish. From 1970 to 1993, the real value of exports from Latin America grew 3.6 percent annually, its terms of trade increased slightly (0.21 percent annually), and the real purchasing power of export earnings increased 3.8 percent yearly.7

Moreover, when export growth is sluggish, the cause is not structural but an overvalued domestic currency relative to foreign exchange. Assume the market-clearing exchange rate is 50 pesos per dollar and the actual exchange rate 25 pesos per dollar. The farmer selling $1,000 worth of sugar cane on the world market receives only 25,000 pesos at the existing exchange rate rather than 50,000 pesos at an equilibrium rate. Devaluing the domestic currency to reflect the market exchange rate would spur farmers and other producers to export.

All in all, cost–push inflation generated by import substitution, decline in the terms of trade, and inelastic agricultural supplies are of limited use in explaining the chronic high rates of inflation found in many Latin American countries.

EXPECTATIONAL INFLATION

Inflation gains momentum once workers, consumers, and business people expect it to continue. Inflationary expectations encourage workers to demand higher wage increases. Business managers expecting continued inflation grant workers’ demands, pass cost increases on to consumers, buy materials and equipment now rather than later, and pay higher interest rates because they expect to raise their prices. Lenders demand higher interest rates because they expect their money to be worth less when the loan is repaid, after prices have risen. Consumers purchase durable goods in anticipation of higher future prices. Thus, once started, expectations can engender an inertia that makes it difficult to stop an inflationary spiral (Fusfeld 1976:332; Heilbroner and Galbraith 1990:398–399; Case and Fair 1996:761–762).

A major justification for wage–price controls is to break the vicious circle of inflationary expectations among workers, consumers, and business people. But, as noted

7Computed from IMF (1988:59–137); IMF (1994:119–186). See also Cline and Associates (1981) and the discussion of the long-run terms of trade in Chapter 17.

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earlier, few LDC wage–price controls are effective, and people may view any success controls have as an aberration rather than as a basis for changing long-run expectations.

POLITICAL INFLATION

In the 1950s, 1960s, and early 1970s, some Chileans explained their chronic hyperinflation as “a ‘struggle’ or even ‘civil war’ between the country’s major economic interest groups.” Albert O. Hirschman (1963:192–223) contends that in Latin America, inflation, as civil war, can be caused by “a group which wrongly believes that it can get away with ‘grabbing’ a larger share of the national product than it has so far received.” When communication among economic groups is poor, one or more classes may overestimate its strength and make excessive money demands that can be worked out only through inflation. Such a process may reduce tension that may otherwise result in revolution or war. Many LDC ministers of labor have averted a political strike by granting inflationary wage increases. As Russians stated during the 1992–95 hyperinflation, “inflation is a substitute for civil war” and “nobody has died yet from inflation” (Popov 2001:43).

Social tensions and class antagonisms causing this political inflation are too deep seated to be cleared up by short-run government policies. In fact, the political threat of the conflict may be so great that the government may have little choice but to tolerate persistent inflation.

MONETARY INFLATION

Monetary policy in low-inflation environments rarely considers the supply of and demand for money (Leeper and Roush 2003; Svensson and Woodford 2003). Indeed, according to Rudiger Dornbusch (1993:1), Milton Friedman’s view that “inflation is always and everywhere a monetary phenomenon,” although sometimes true, usually is not true. Identifying when monetarism is relevant is an art. In the United States, Dornbusch continues, the monetarist “comes out of the corner” during inflation but “stays in hiding” when there is no inflation. In the United States, Dornbusch (1993:1) asserts: “Monetarism does not do a lot for us, no more at least than the prediction that it is colder in winter than in summer.”

Similarly, in LDCs, monetarism has little explanatory value except during high inflation, as during the late 1980s or early 1990s in Latin America, the former Soviet Union, and parts of Eastern Europe and Africa. According to Robert McNown and Myles S. Wallace (1989:533–545), monetary growth outweighs real shocks in explaining price increases during high inflation, as occurred in Brazil, Chile, Argentina, and Israel in the 1970s and 1980s. High inflation not only occurs during civil war, revolution, deep social unrest, and weak government, but also with external shocks (such as the German reparation payments in the 1920s, the oil price hikes of 1973–75 and 1979–80, and the debt crisis and high real interest rates of the 1980s). Monetary expansion contributes to inflation, while rapid inflation wipes out the real value of tax revenues, increasing budget deficits and accelerating money

growth, thus strengthening the link between financing the budget and the growth of money (Dornbusch 1993:1–2; Sachs and Larrain B 1993:723–27).

INCOMES POLICIES AND EXTERNAL STABILIZATION

The price of foreign exchange plays an important role in spurring on inflation. In many instances, hyperinflation is triggered by a balance-of-payments crisis and the resulting currency collapse. The increased price of foreign inputs to domestic production provides a stimulus to cost–push inflationary pressures.

Stabilizing high inflation requires budgetary and monetary control, increasing tax yields, external support (to reduce supply-side limitations), structural (supply-side, many middleto long-run) reforms (Chapter 19), and incomes policies to reduce inflationary inertia. Providing external loans so the country has ample reserves for imports is one way to provide assurance for the foreign-exchange and capital markets, and increase the likelihood the reserves do not have to be used. Incomes policies, such as freezing exchange rates, wages, and prices for a few months can effectively supplement domestic budget cuts. Relying on demand management (contractionary monetary and fiscal policies) alone without incomes policies will create an extraordinary depression. Dornbusch (1993:1–3, 13–29) suggests fixing the price of foreign exchange without overvaluation for two to three months (to reduce inflation inertia), then eventually using a crawling peg, which depreciates home currency continuously so the exchange rate facilitates external competitiveness.8 Fischer (2001b:6) thinks that there are few instances of “successful disinflation from tripledigit inflation . . . without the use of an exchange rate anchor.” Mexico used a crawling peg in 1993–94 but, in the face of rising U.S. interest rates in 1994, the band within which the peso price of the dollar could “crawl” (read increase) to maintain balance-of-payments equilibrium was too narrow, thus triggering a foreign-exchange crisis in late 1994 and early 1995 (Lusting 1995:C-5). In 1991, Argentina pegged the peso to the dollar and established a currency board to limit domestic currency issue to 100 percent of foreign currency and reserve assets, policies that generated an “inflation miracle” – slashing inflation from 3,080 percent annually in 1989 and 2,315 percent in 1990 to 172 percent in 1991, 25 percent in 1992, 11 percent in 1993, and 4 percent in 1994! However, critics contend that after peso stabilization, Argentina suffered from a loss of competitiveness from a peso overvalued relative to dollar, as suggested by a shift from a current-account (international balance on goods, services, income, and unilateral transfers) surplus of $4.5 billion in 1990 to a current account deficit that continued from 1992 to the peso collapse and Argentine default of 2001 (IMF 1992:19; Economist 1994a:76; IMF 1994:25; Mussa 2002).

8McKinnon (1993:106–07) recommends indexing the peg to the change in the domestic general price index relative to the change in the foreign general price index.

An IMF panel analyzing the uses of exchange rates to steady prices in high-inflation economies was skeptical about fixing the price of foreign exchange for any length of time. In some instances, the IMF panel granted, a country could successfully use the exchange rate as an anchor when this policy was accompanied by a credible program of fiscal restraint. “Using Exchange Rate Anchors in Adjustment Programs: When and How?” IMF Survey (November 20, 1995), pp. 361–363.