Issues in Income Tax Reform in Developing Countries

TLDR: In this article, the authors compare the cost of financing industrialization in the United States and in Germany during the second industrial revolution and conclude that the potential to expand quickly and reap economies of scale was greater in German industrialization.

Abstract: Developing countries designing financial systems should take a lesson from U.S. financial history and avoid a costly, lengthy detour through financial fragmentation. In universal banking, large banks operate extensive networks of branches, provide many different services, hold several claims on firms (including equity and debt), and participate directly in the corporate governance of firms that rely on the banks for funding or as insurance underwriters. Would universal banking be effective in a newly industrializing economy? Does universal banking reduce corporate financing costs for a newly industrializing economy? Calomiris contrasts the cost of financing industrialization in the United States and in Germany during the second industrial revolution. Between 1870 and 1913, large production and distribution activities brought a new challenge to financial markets: the rapid financing of very large, minimally efficient industries. Large production is typical of modern industrial practice, so the lessons from that period apply broadly to contemporary developing countries. The second industrial revolution involved many new products and technologies, especially involving machinery, electricity, and chemicals. The novelty of these production processes posed severe information problems for external sources of finance. Firms were producing new goods in new ways on an unprecedented scale. Firms needed quick access to heavy financing from sources whose information and control costs were greater because of the difficulty of evaluating proposed projects and controlling the use of funds. Finance costs for industry were lower in Germany than in the United States, because U.S. regulations prevented the universal banking from which Germany benefited. High finance costs retarded U.S. realization of its full industrial potential and influenced U.S. firms inefficiently to rely more on raw materials and labor rather than on hard-to-finance equipment (fixed capital). Industrial buildings and equipment are less desirable than materials and accounts receivable for a financially constrained firm, because they are less liquid. The potential to expand quickly and reap economies of scale was greater in German industrialization. The cost of industrial financing began to decline when institutional changes came about that increased the concentration of financial market transactions. In recent decades, a combination of macroeconomic distress, international competitive pressure, and the creative invention of new financial intermediaries has helped the U.S. financial system overcome the regulatory mandate of financial fragmentation. This paper - a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department - was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.