Informal fiscal systems in developing countries

Governments in developing countries have low fiscal capacity yet face pressures to provide public goods and services, leading them to rely on various unusual fiscal arrangements. We uncover one such arrangement – informal fiscal systems that rely on local bureaucrats to fund the delivery of public goods and services – cataloging its existence in at least 20 countries. Using survey data and government accounts from Pakistan, we show that public officials are expected to cover funding gaps in public services and they do so, at least partially, through extracted bribes. We develop a model of bureaucratic agency to explore when governments benefit from sustaining such systems and investigate their implications for welfare and bureaucrat selection. Informal fiscal systems are more likely to arise when corruption is widespread but public service delivery is relatively easy to monitor. While they provide an effective second-best solution in the presence of moral hazard and adverse selection, they can distort the effective incidence of the tax burden, reduce the incentives of governments to fight corruption, and legitimize bribe-taking. This makes corruption more widespread and thus makes informal systems self-reinforcing.