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 document one such - hitherto unexplored - arrangement: informal fiscal systems that rely on local bureaucrats to fund the delivery of public goods and services. 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 propose a model of bureaucratic agency to explore when governments benefit from sustaining such systems and investigate welfare implications. Informal fiscal systems are more likely to arise when monitoring corruption is difficult relative to monitoring the provision of public services, and politically-important groups of citizens do not bear the full cost of corruption. The existence of such systems can distort the effective incidence of the tax burden, reduce the incentives of government to fight corruption, and legitimize bribe-taking.