hypothesis is that lower bureaucratic quality is correlated with lower taxable capacity, other things being equal.

To ensure consistency, all data on tax-GDP and fiscal revenue-GDP ratios are taken from the same sources, WDI 2006. It is worth noting that sub-national revenue data from either WDI or IMF Government Finance Statistics are largely missing, and due to the limitation of the statistics, the analysis covers only the tax and revenue collection at the central level. The data tend to under record the tax level in countries with significant collection at the subnational levels, which Bird et al. (2004) has also cautioned about. After checking outliers, we have excluded Kuwait and United Arab Emirates from the sample as these oil abundant countries appear to rely mostly on royalties and fees from natural resources.

Annex 2 presents the statistics for all variables. Annex 3 presents the period average of data by variable and country during 1994-2003. Annex 4 summarizes the statistical correlation across variables. It is observed that all the intended independent variables, GDP per capita, population growth rate, age dependency ratio, trade openness, agriculture value added, corruption index and bureaucratic quality indicator, have the predicted sign of correlation with either tax or revenue-GDP ratios. In addition, all the correlations are sizable, ranging from 0.35 to more than 0.6 in absolute terms (Annex 4).

Several considerations regarding the model specification should be mentioned. First, there are a number of institutional variables that have high correlation. For example, bureaucratic quality highly correlates with political stability and rule of law—leading to constraints in using a larger number of the institutional variables without the risk of multi-colinearity. Second, some of the institutional variables may be endogenous. For example, a conventional conjecture is that higher institutional quality may lead to higher taxes and revenues, and on the other hand, better tax and revenue performance may result in higher institutional quality. Bird et al (2006) test the presence of endogeneity problem, applying 2-Stage Least Squares (2SLS) approach and Hausman Chi-square test. The instrumental variables include ethnic fractionalization, language, and latitude. The Hausman Chi-square tests fail to detect the presence of simultaneity of the tax/revenue effort and institutional variables.

# **_Empirical Estimation of Tax and Total Fiscal Revenue Capacity_**

The empirical results are presented in Tables 1 and 2 for taxable capacity and for fiscal revenue capacity, respectively.<sup>10</sup> Each table has two panels: panel A presents results of the specifications using population growth as proxy for the demographic influence on taxable capacity, and panel B replaces population growth with age-dependency ratios. The regressions capture the entire period of 1994-2003 and the two sub-periods of 1994-1998 and 1999-2003 to test the dynamics of tax and fiscal revenue capacity. In each table, equation 1 (the first column of the estimated coefficients) represents the regression on traditional tax

> 10 As previously defined, taxable capacity refers to the predicted tax-GDP ratio on the basis of a regression accounting for a country’s specific tax handles and quality of institutional setting, and the similar concept of (fiscal) revenue capacity refers to the predicted revenue-GDP ratio.

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