Untapped Tax Revenue and Sovereign Credit Ratings

Do sovereign credit ratings reflect how much of their fiscal potential governments leave untapped? We estimate tax potential with a stochastic frontier and measure the tax gap as the share of this potential that remains uncollected, which averages 35% in our sample, 30% in advanced economies and 38% in emerging and developing economies. Using panel local projections for 133 countries over 1990–2021, we find that a one-standard-deviation increase in the tax gap, about 4.1 percentage points of potential, is followed by a gradual decline in the sovereign rating, which peaks after about four years at 0.13 to 0.20 notches, depending on the estimator. Such an increase raises the net probability of a downgrade by about 4 percentage points within three to four years. Ratings follow the tax gap with a lag and return to their initial level only once the gap has closed, about a decade after the shock. The decline is not driven by falling revenue. A fall in revenue has only a short-lived effect, whereas a widening of the gap at a given level of revenue, which signals a tax base that expands without being taxed, has twice the baseline effect. Untapped fiscal potential is thus read as a sign of potential fiscal weakness rather than as fiscal headroom. The response is present in both advanced and developing economies, peaking earlier in the latter. It is stronger in countries that rely on taxation rather than natural resource revenue, outside IMF programs, and when uncertainty is high.