# **1 Introduction**

What social rate of return should public infrastructure projects be required to achieve in Africa? What is the next challenge in the reform of African tax structures? The answers to these questions require knowledge of the marginal cost of public funds (MCF). If a project does not yield a social return greater than the MCF, it is not worth having. Holding revenue constant, welfare can be increased by reducing taxes with high MCFs and increasing taxes with low MCFs, so estimates of MCFs provide directions for reform of tax structures.

The central role of the MCF in these important public policy issues is well known. So it is surprising that there are few empirical estimates of MCFs. Table 1 summarizes existing estimates. We know of only three papers in which estimates of the MCF have been derived for developing countries. We know of only one African country, Cameroon, for which the MCF has been estimated. Moreover, for methodological reasons existing estimates are not all truly comparable.

Perhaps the major reason for this relative paucity of MCF estimates has been the amount of data required and the time expense of creating and calibrating the computable general equilibrium (CGE) models used for estimation. CGEs are required because real tax systems are complex, and because it is necessary to take account of multiple interactions within tax systems.<sup>1</sup> Thus, the challenge as we have conceived it is to develop a simple CGE model that can be calibrated with little more than national accounts data, and which can be used to provide consistent estimates comparable across countries. To be useful for tax policy analysis, the model should take account of the major classes of taxes in African countries: taxes on domestic goods, exports, imports, corporate income tax, and personal income tax. On average, in the Sub-Saharan African countries that we examine, these taxes represent respectively 25%, 3%, 35%, 13%, and 14% of tax revenue, with the remaining 10% coming from other sources.<sup>2</sup> A key requirement for realism is that the model should take account of the existence of informal sectors, which occupy a larger part of the economy in Africa than elsewhere. For example, Schneider & Enste (2000) report the shadow economy occupied on average 15% of GDP in OECD countries in 1990, but 27% in Botswana and 76% in Nigeria.<sup>3</sup> We might suspect that in countries with larger informal sectors, it is easier for economic agents to shift from formal to informal activity. Greater substitutability would lead to higher marginal costs of taxation on formal activity. The presence of an informal sector has been shown to have a noticeable

> 1To provide the intuition for the effects of key parameters, analytical models with minimal data requirements were used in initial development of the theory (e.g. Stuart (1984), Mayshar (1991), Snow & Warren (1996)). But there are limits to the complexity of models that can be solved analytically.

> 2Eighteen countries in our sample do not use export taxes. Among the twenty countries that do use them export taxes constitute 7% of tax revenue.

> 3These figures are estimated using physical input methods.

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