How Does Financial Sector Development Improve Tax Revenue Mobilization for Developing Countries?

This study examines the effect of financial development on tax revenue mobilization in developing countries. Our empirical analysis uses the aggregate financial index that comprises the banking system's depth (size and activity), access, and efficiency of financial institutions and financial markets. Using panel data from developing countries over the period 1995–2017, our findings suggest that more developed financial sectors positively and significantly influence the government's ability to raise tax revenue. The results also support a positive effect of financial development on all sub-components of total tax revenue. More specifically, the development of the financial sector improves the mobilization of direct taxes more than the one for indirect taxes. More interestingly, this favorable effect is sensitive to developing countries' characteristics, namely the level of economic development, the degree of financial openness and the stance of fiscal policies. When we more precisely look at the effects of disaggregated financial development components on tax revenues mobilization, we find that the estimated coefficients on the sub-components of financial development are statistically significant, except for the financial market's efficiency. The results denote that tax revenue in developing countries depends on financial institutions and financial markets.