When is innovative finance good for development?

There are bad reasons and good reasons for supporting the use of innovative finance for development. Unfortunately, some development advocates seem williing to back any proposal that they think might raise more money for development, instead of focusing on mechanisms that will improve the way that money is used.

When is innovative finance good?

Innovative finance can improve the effectiveness of aid spending. There are at least four ways this can work.

First, innovative finance can improve intertemporal optimisation.  Aid budgets are often given from year to the next, which makes it difficult to spend the money at the best time.   For some spending, it makes sense to spend today to save money tomorrow (for example, spending money to eliminate smallpox reduced the need for health care spending later on).   It is not always sensible to bring forward spending – particularly if you believe that there are diminishing returns to some kinds of aid spending. The International Finance Facility for Immunisation is a good example of how spending tomorrow’s aid today can be sensible, because future generations benefit from the increase in herd immunity in today’s beneficiaries.

Second, innovative finance can create a commitment technology.   There are many benefits to being able to make commitments – which is why in normal life we have mechanisms such as contracts and warranties.   We need commitments to deal with dynamic inconsistency and to allocate risks.  But constraints on aid agencies make it very hard for them to make commitments about aid.  A good example of an effective forward commitment is the Advance Market Commitment, which guarantees manufacturers a more lucrative price if they develop and produce a new medical product for developing countries.  Forward commitments enable governments to invest in reforms which have costs over several years, or firms to invest in new products for developing countries.

Third, innovative finance can change incentives both for donors and recipients.  For example, funding schemes that link payments to results may reduce the incentives of donors to micromanage the way aid is used.  If payments to organisations are linked to demand (eg through a virtual voucher scheme) they may improve their services for beneficiaries.

Fourth, innovative finance can improve the allocation of risk.  Insurance pools may diversify risk, and permit rapid increases in funding in the case of disasters.  We can pool medicines, for example, so that they are available to whoever needs them first.  Stabilization funds with automatic disbursement criteria can ensure that finance is rapidly available, without strings, where and when it is needed.

In each of these four cases, well-designed innovative finance can increase the productivity of aid spending.  As aid becomes demonstrably more effective, so in the long run we can make the case for greater investment.

When is innovative finance not good?

While there are excellent reasons to identify innovative ways to give aid, the need to increase funding is not one of them.  I am in favour of a large increase in aid, but not in favour of achieving it by distorting rational decision-making on taxation and spending.   Many development advocates support schemes to tax financial transactions (a so called “Tobin Tax”) or airline tickets, or a new global lottery (a tax on the poor), if these are used to pay for increased foreign assistance.    I understand the desire to get aid any way we can, but I don’t respect this kind of opportunism.

We should determine the structure and level of taxes on the basis of evidence about the most effective (or least damaging) ways of raising the revenues we need; and we should decide the level of spending on the public’s various priorities based on how we will do the greatest good.  Linking a particular kind of spending to a particular revenue  cannot improve choices about spending or tax, and may unnecessarily constrain them.

Conclusion

Some particularly misguided proposals involving introducing taxes on goods or services we would not normally considering taxing (such as investment in information technology).  By linking these proposal to the (rightly appealing) goal of increasing aid spending, we are in danger of being seduced into doing the wrong things for the right reasons.

Innovative finance holds rich possibilities for accelerating poverty reduction by making aid money work better.  If we can find ways to relax the institutional constraints on spending money at the right time, or increase our ability to make rational commitments, we can make aid money work harder.  In time, this may mean that taxpayers and donors are willing to spend more.  But we should not invent mechanisms whose main effect is to bypass our existing processes for making sensible decisions about tax and spending.

3 thoughts on “When is innovative finance good for development?”

  1. Financing global development: The good, the bad, and the ugly?

    In the terrific piece above Owen Barder sets out four reasons why innovative aid finance mechanisms are good. They can improve intertemporal optimization (the International Finance Facility for Immunization); create a commitment technology (Advance Market Commitments); change incentives; and improve the allocation of risk.

    Too bad he then proceeds to write off the Tobin tax (which Dani Rodrik likes) and presumably other (mostly French) ideas for earmarked “global” taxes, on the grounds that they distort rational decision-making on taxing and spending. True any global tax is a non-starter politically in the U.S. (not only because tax is a dirty word but because Americans will never support a tax without clarity on who and how it will be spent, matters that are rarely discussed by advocates of raising “global” revenue). On the other hand, conceptually I can convince myself they are reasonable. All taxes and especially earmarked taxes are non-optimal. But we live in a second-best world. In a global system with global public goods and bads, in which the politics of raising revenue domestically to deal, say, with adaptation to climate change in developing countries is tough, a tax on global financial transactions – or on airline tickets is not opportunistic as Owen suggests. It’s some odd combination of idealism and pragmatism!

    1. Nancy – Thanks. I guess you can take the man out of the Treasury but you can’t take the Treasury out of the man.

      Where I think we differ is that I don’t think you can use “second best” as a get-out-of-jail-free card. We do live in an imperfect world, but that does not mean that anything goes.

      I think we would both agree that the best way of bringing new money in to development is to use the money better, and to demonstrate that we are using it well. If we did that, we wouldn’t need to invent ways to bypass our budget systems.

      Owen

  2. Come to America and stay in a hotel on the left coast (San Francisco) or rent a car at Reagan Airport (Washington, DC). The accumulated taxes on the car are around 40%, the taxes on the room are around 15%. And eat at a restaurant in San Francisco and they add in a health surcharge, which is either a tax, an optional tax or simply a reason to eat in some other city. So the “dirty word” is more related to the seemingly inexhaustable list of taxes, surcharges and fees that already exist.

    Time was when Americans would brag about how much they paid in federal income taxes (granted 50-60 years ago) They were then contributing to what was seen as a common good. Vice the current system that appears to be an accumulation of every special interest group that can clain victim status in the mind of political entity. Therein lies the dirty word.

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