Precept 7

Precept 7

The government should invest revenues to achieve optimal and equitable outcomes, for current and future generations.

Resources can propel economic growth, yet this has often failed to benefit the poor. Zambia’s GDP per person rose over 30 percent from 2003 to 2010, yet the share of income for the bottom 20 percent fell from 6.2 percent to 3.6 percent.
—Calculated from World Bank Development Indicators.

The government must decide how to allocate the revenues from resource extraction. Possibilities include but are not limited to: allocate revenues directly into national or sub-national budgets; use them for tax reductions, or transfer payments, such as welfare payments, subsidies or "resource dividends"; contribute to pension funds or natural resource funds; capitalize lending institutions; or retain/allocate revenues to a national company.

In making these choices, the government should consider two overriding objectives: promotion of equity, both between generations, and across society; and efficient use of revenues to maximize welfare.

See Precept 8 on revenue volatility.

The nature of resource revenues complicates this problem in four ways. First, non-renewable resource extraction is intrinsically unsustainable. The country must plan for a time when commercial reserves are depleted, or at least when the available revenue streams decline. This running down of a natural asset requires actions to accumulate equivalent productive assets, typically physical or human capital. Second, resource revenues typically exhibit large booms as extraction projects produce at full capacity, followed by long declines as the reserve is depleted; so the government must make decisions about large amounts of money, relative to the overall size of the economy, in a short span of time. This means that in most years the amount that the government should consume should be less than it earns, so some form of saving is required.

See Precepts 9 and 10 on enhancing the absorptive capacity of the economy.

Third, commodity prices and therefore resource revenues are typically volatile on a year-to-year basis. This requires policy instruments that ensure that short-term revenue fluctuations do not translate into disruptive government spending fluctuations. Fourth, revenue flowing into the economy can produce adverse macroeconomic responses. Large flows of money into the economy alongside a higher demand for non-tradable goods and services can cause a deterioration of businesses that produce goods for potential export, a phenomenon called "Dutch disease." Also, a build-up of assets or expectations of future revenue streams can cause credit bubbles and similar financial issues. In addition, the economy may lack the absorptive capacity to handle a large increase in domestic investment in the short term, causing inflation. Finally, conflict may arise if citizens perceive that the benefits of resource extraction are not distributed fairly.

Ensure equitable allocation for future generations

See Precept 3 on the importance of understanding the resource base, resource depletion and ensuring revenue stream to inform this savings decision.

To achieve the first objective, promotion of equity, the government should decide how much of the revenue should benefit citizens in the present, and how much to invest for future generations. This decision rests on a reasonable estimation of how much resource revenue will be available to spend or save, and on the growth prospects of the country. If high growth takes place, present-day citizens are likely to be much poorer vis-à-vis future generations; some immediate spending to improve the welfare of present-day citizens is required. However, government should weigh this consideration against the capacity of the economy to absorb potentially large increases in spending. In countries with slower expected rates of income growth, there will likely to be a smaller gap between the incomes of current and future generations. In such cases, government should ensure that less revenue is consumed in the present, and more is invested to maintain equity between generations.

In addition to more equitable distribution over time, some current expenditure of revenues may be important to demonstrate effective public spending and to cement public support for governments’ long-term resource management plans. The advent of resource wealth carries the danger that public expectations will become too high, and competing interest groups demand shares of the proceeds. Managing these expectations through open and inclusive national planning, and communication of the facts, can limit the demands and subsequent over-spending. While some consumption may be warranted in poorer countries, often the default response from any political system is to consume as much of the revenues as possible: countries must protect the rights of younger and future generations to benefit from the country’s wealth.

Oil-exporting countries are among the biggest subsidizers in the world—US$137 billion in all combined, over 70 percent of all direct global oil subsidies (as of 2010). However, subsidies do little for poverty alleviation. On average, the richest 20 percent of households in low- and middle-income countries capture six times more in subsidies than the poorest 20 percent of households.
—Carlo Cottarelli, Antoinette Sayeh and Masood Ahmed, 2013.

An explicit fiscal rule dictating the amounts spent and saved each year by government can guide the long-term decision to save. To protect against government’s temptation to renege on this rule, it is important that the rule itself and the amounts spent and saved each year are made public. Together with strong oversight from civil society and independent authorities, these governance structures can help keep government to its decision.

Consider equity amongst today’s citizens

In allocating revenues, government should also consider equity amongst today’s citizens. This may necessitate careful consideration (and intervention) to balance the distributional equity of benefits according to social group, gender and income level.

The government may wish to use resource revenues to support those living in relative or absolute poverty. The government can do so through a variety of channels (see below) and may need to balance the trade-offs between more efficient channels and those that reach a greater number of targeted groups.

Since unconditional lump-sum transfers would benefit the poor more relative to the rich, there may be some justification for these direct transfers in countries with high levels of poverty and credit constraints. Direct cash transfers to people can help relieve household spending bottlenecks, capacity constraints and individual credit constraints. They may also generate public interest in how revenue is spent, thereby strengthening the desire to hold government to account.

However, successful transfers of this kind rely on public administration systems that can distribute funds effectively, otherwise misappropriation can occur. Furthermore, cash transfers may conflict with government objectives to use resource revenues to invest if citizens do not invest the cash themselves, while in addition cash transfers reduce the funds available for public sector projects. Further, authorities ought to pay close attention to the absorptive capacity of the economy. If businesses cannot suitably respond to additional demand created by cash transfers, the transfers will merely cause domestic price inflation.

Subsidies are typically the least desirable method to distribute revenues, despite their widespread use and popularity. Fuel subsidies in particular may be demanded by members of the public as their right as citizens of a resource-rich country. However, subsidies can spur wasteful consumption, smuggling, and the development of parallel markets. When the domestic commodity price is subsidized, high world prices cause a loss of export earnings and a high burden on government finances, undoing the benefits of higher resource revenues.

The central government should consider the social returns on regional investments, which may necessitate a focus on specific regions, such as cities as engines of job creation and growth. Furthermore, the central government should link revenue distribution to the expenditure responsibilities of local governments, and be pro-active in building the capacity of local governments to manage these responsibilities.

See Precept 5 on compensation to local communities

In some cases the government may consider distributing more revenues to communities near to extraction sites than communities elsewhere in the country. Where groups disproportionately bear the costs of extraction—such as environmental damage or social disruption—the government should actively seek to prevent or compensate for this. In addition, to mitigate conflicts or social tensions, the government may wish to distribute some share of revenues to communities near extraction sites. However, where resources are nationally owned, communities near to extraction sites typically have no inherent claims on a greater share of resource revenues than other communities within a country, and the government may need to balance local requests against the needs of all its citizens.

Ensure investment is efficient

The second revenue management objective is to allocate revenues so they can provide the greatest social return. In making this decision, it is important for the government to consider not only purely financial benefits, but also economic and social benefits such as job creation and skills transfer.

Collecting the revenues is not enough if they are siphoned off before they can be used to drive development. In Cameroon, as in 19 other countries assessed in the Resource Governance Index, substantial revenues appear to bypass the national treasury entirely.
—Revenue Watch Institute, 2013.

A key choice is between making domestic or foreign investments. For a country with good infrastructure and public services, more domestic investment is less likely to earn returns that are as high as investing abroad. But a poorer country is typically trapped—it may lack the infrastructure and public services to attract private investment. Yet without such investment, the government cannot earn revenue to fund public infrastructure and services. If in receipt of resource revenues, the government has an opportunity to break this cycle by funding the structural changes required to attract foreign business investment. A developing country in such circumstances will realize greater benefit from government’s domestic investment, particularly if paired with complementary private investment, than from the government investing abroad.

See Precepts 9 and 10 on using revenues to address investment constraints.

In this way, investing resource revenues in the domestic economy is likely to be the best course of action for many low-income countries in the long term. However, poor public project selection, delivery and cost inflation can render sharp increases in domestic investment ineffective. Especially where infrastructure is poor, government and businesses may have limited capacity to respond to the higher demand from large spending programs, so that investing resource revenues in the economy results in inflation rather than better capital goods. This lack of "absorptive capacity" may arise from low bureaucratic capacity, or bottlenecks such as congested port facilities or urban transport networks. Resource revenues provide an opportunity for governments to address these constraints in a sequenced manner. However, because these efforts take time, initially surplus revenues might be held in savings funds abroad, or used to pay down foreign-denominated debt. The latter use can be particularly beneficial for an economy. Foreign debt reduction raises no domestic absorption issues, enhances the country’s credit standing and appeal to investors, and—most importantly—reduces the cost of investment for the domestic private sector via its effect on interest rates.

Using revenues to capitalize government-sponsored lending institutions (such as development banks or mortgage providers) shifts the decision about the use of revenues to an institution that may have greater knowledge and specialist expertise to make the decision than central government. If there is sufficient capacity and robust governance standards are in place, such institutions may choose investments that provide greater social returns than those that central government decision-makers might select.

In some cases, the private banking sector may have greater capacity and incentives to find the best financial returns for resource revenues. However, if the domestic investment climate is incapable of offering suitable financial returns, private banks may instead invest funds abroad, even if there are opportunities to make non-financial returns for society in general. The government might consider using resource revenues to instead enable conditions for private domestic investment in the future.

Further Precept Details