What Is Fiscal Capacity?

Fiscal capacity, in economics, is the ability of government, groups, and institutions to generate revenue. The fiscal capacity of governments depends on a variety of factors including those that contribute to the tax base. It also includes the government’s ability to efficiently tax and its compensating behavior among taxed individuals, markets, and asset prices. Access to other non-tax forms of revenue will add to a government's fiscal capacity.

Understanding Fiscal Capacity

In order to fund basic operations, provide public goods, and achieve other policy objectives, governments need revenue. They can raise revenue by imposing taxes, selling assets or resources, or receiving transfer payments from other outside governments or entities. Fiscal capacity is the degree to which a government is able to raise such revenues. 

When governments develop their fiscal policy, determining fiscal capacity is an important step. Identifying fiscal capacity gives governments a good idea of the different programs and services—such as pensions—that they will be able to provide to their citizens. Governments must consider the impact of such benefits not only on the current year but their impact on the future revenue stream.

The theory behind fiscal capacity can also be used by other groups, such as school districts, who need to determine what they will be able to provide to their students.

Available Tax Base

Raw fiscal capacity starts with a government’s available tax base. The famous American bank robber, Willie Sutton, when asked why he robbed banks is reputed to have replied, “Because that’s where the money is.” A government’s fiscal policy fundamentally starts in the same way: by assessing where the various sources of wealth and income in its community lie. The valuable real estate, profitable businesses, and personal incomes of its citizens and subjects, and those with whom they transact business, from which a government can extract revenue make up the tax base. The wealthier and more productive the available population of potential taxpayers that a government has access to, the larger the tax base and the base fiscal capacity. 

However, other factors may influence a government’s ability to actually collect revenue from the tax base. A government’s ability to tax certain types of property, income, or economic activity may be limited by constraints placed upon it by voters, by constitutional restrictions, or by other governmental entities (perhaps so that they may tax it themselves).

Beyond these constraints, a government’s technical and logistical capacity to administer, collect, and enforce a given tax may be finite and insufficient to fully exploit the existing tax base. Like any entity or organization, governments are subject to the fundamental economic problem of scarcity and inevitably face trade-offs in how they allocate the scarce labor and equipment that they actually use to tax. 

Limiting Fiscal Capacity

Actual fiscal capacity can also be limited by compensating behavior on the part of businesses and individuals who are subject to taxes, which may reduce the amount that the tax base can actually be taxed. The Laffer Curve is a famous illustration of this kind of limit on a government’s ability to extract the full value of its tax base. Taxing any activity will to some degree discourage that activity, reducing the apparent tax base available.

Some taxes may even be deliberately intended to reduce certain activities over time, such as taxes on cigarettes or carbon taxes, but in doing so also obviously reduce the revenue that can be raised thereby. Market participants can capitalize the burden of property taxes (and expected future increases in property taxes) on real estate or other assets into the market values of assets, potentially directly reducing the size of the tax base. 

People may be able to avoid or evade a tax by physically moving beyond a government’s jurisdiction or by transferring activity into the informal economy. Governments with a weak ability to monitor economic activity or enforce tax law may be especially vulnerable to this. Lastly, increasing taxes may evoke political resistance depending on the preferences and attitudes of voters, the degree of political voice and participation given to the people, and the extent to which voters and taxpayers are the same people. This can place a firm limit on a government’s fiscal capacity even with an apparently large and wealthy tax base.

Other Sources of Revenue

Beyond taxes, governments may have access to other sources of revenue that can contribute to their fiscal capacity. Transfers from other governments, such as grants from the U.S. federal government to state and local governments, can increase fiscal capacity but are normally subject to a variety of political considerations for their size and availability. Some governments may directly lay claim to various natural resources such as crude oil reserves or undeveloped land, which can be sold off for revenue. The market prices of these resources and the specifics of contracts involved in selling them (or partial rights to them) will determine their contribution to a government’s fiscal capacity.