Fiscal consequences of armed conflict and terrorism in low- and middle-income countries

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Abstract

The paper examines the fiscal effects of armed conflict and terrorism on low- and middle-income countries using two approaches. First, an analysis of 22 conflict episodes shows that armed conflict is associated with lower growth and higher inflation, and has adverse effects on tax revenues and investment. It also leads to higher government spending on defense, but this tends to be at the expense of macroeconomic stability rather than at the cost of lower spending on education and health. Second, econometric estimates provide some support for the hypothesis that conflict and terrorism have a significant negative impact on growth through changes in the composition of government spending. There is also some evidence that armed conflict has a direct, significant impact on growth, independent of its impact on government spending. Thus, there is potential for a sizable “peace dividend” for countries that are able to resolve conflict and terrorism.

Introduction

Contrary to expectations, the end of the Cold War has not been a harbinger of peace. There has been a proliferation of armed conflicts around the world over the past dozen years. In particular, terrorist groups have become increasingly sophisticated, daring, and destructive. More than 4 million people are estimated to have perished in violent conflicts between 1989 and 2000, and 37 million people have been displaced as refugees, either inside or outside their countries (World Bank, 2000). In 2000, there were 25 major armed conflicts around the world, of which 23 were intrastate conflicts (SIPRI Yearbook, 2001)1. International terrorist attacks increased from an average of about 342 a year between 1995 and 1999 to 387 a year between 2000 and 2001.2 Most of the armed conflicts and terrorist activities have taken place in low- and middle-income countries. Between 1996 and 2000, almost 70% of the major armed conflicts, more than 20% of all international terrorist attacks, and over 70% of all casualties due to such attacks, took place in Asia and Africa.

While the literature has documented the economic costs of armed conflict and terrorism, a cross-country examination of their fiscal consequences is yet to be undertaken. Armed conflict and prolonged terrorist activities can strongly influence the revenues and expenditures of countries, and in turn affect their economic growth. Although armed conflict and terrorism are often treated as distinct phenomena, experience from different parts of the world shows that there is a close link between the two. This paper analyzes the effects of armed conflict and terrorism on fiscal balances and economic growth in low- and middle-income countries.

The remainder of this paper is structured as follows. Section 2 provides a brief overview of the literature, followed in Section 3 by a description of the channels through which armed conflict and terrorism can affect the fiscal accounts and economic growth. Section 4 sets out the methodology for the empirical analyses presented in the paper. Section 5 compares the evolution of various macroeconomic variables and socioeconomic indicators before, after, and during 22 episodes of armed conflict in a number of low- and middle-income countries. Section 6 estimates an integrated system of equations for real per capita income growth, government revenue, and government spending, to highlight the main channels through which armed conflict and terrorism affect the fiscal accounts. Section 7 concludes.

Section snippets

Review of the literature

Several studies have assessed the economic costs of armed conflicts.3

Fiscal effects of armed conflict and terrorism: potential channels

Armed conflict and terrorism can affect the fiscal accounts by disrupting economic activities, eroding the tax base, lowering the efficiency of tax administration, and distorting the composition of public spending. Tax receipts, for example, vary with the health of the economy. Economic downturns due to insecurity and violence can lead to a decline in tax revenues. Beyond their effects on real activity, armed conflict and terrorism (especially if prolonged) can destroy part of the tax base

Empirical methodology

The empirical analysis in this paper is based on two approaches.

The first approach assesses the impact of armed conflict within conflict-affected countries, by examining the evolution of macrofiscal and socioeconomic variables before, after, and during 22 episodes of conflict in 20 low- and middle-income countries.7

Macroeconomic and fiscal variables and socioeconomic indicators: preconflict, conflict, and postconflict periods

The results from comparing the conflict, preconflict, and postconflict phases of 22 episodes of armed conflicts in lower- and middle-income countries are presented in Fig. 1, Fig. 2, Fig. 3, Fig. 4, Fig. 5 and Table 1. The data on real GDP are consistent with the hypothesis of a significant pickup in growth in the immediate postconflict years. There is a dramatic pickup in inflation during the conflict period, followed by a significant decline in the immediate postconflict period (see Fig. 1,

Econometric estimates

As mentioned earlier, there are three main ways in which armed conflict and terrorism can affect the fiscal accounts: by influencing real economic activity (GDP) and therefore, government revenues; by adversely affecting both the tax base and the efficiency of the tax administration; and by changing the composition of government spending. These fiscal consequences can have repercussions on economic growth, which would further affect the public finances. To capture all these effects, a

Conclusions

The empirical literature on economic costs of armed conflicts and terrorism has yet to provide a comprehensive, cross-country examination of their fiscal consequences. This study provides a cross-country examination using two approaches. First, the evolution of various macroeconomic and fiscal variables and socioeconomic indicators during 22 episodes of conflict, and in the years immediately preceding and following the conflicts, was analyzed. Second, an integrated system of equations for real

Acknowledgements

An earlier version of this paper was presented at the workshop on “The Economic Consequences of Global Terrorism,” held at the German Institute for Economic Research (DIW), Berlin, on June 14–15, 2002. The authors would like to thank Emanuele Baldacci, Hamid Davoodi, Stefano Fassina, Hong-Sang Jung, Mansoob Murshed, Erwin Tiongson, two anonymous referees, and participants of the DIW workshop for useful comments and suggestions.

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