FISCAL POLICY Thorvaldur Gylfason IMF InstituteCenter for Excellence

FISCAL POLICY Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21– 29, 2011

OUTLINE 1. Objectives and uses of fiscal policy Stabilization, allocation, distribution 2. Global financial crisis and fiscal policy response Benefits and risks related to fiscal policy Public debt dynamics Sustainability of public debt Safeguarding fiscal sustainability Exit strategies when things go wrong 3. Fiscal reforms

DEFINITION OF FISCAL POLICY 1. The term fiscal policy refers to the use of public finance instruments to Vito Tanzi influence the working of the economic system to maximize economic welfare 2. Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing 3. Assessing the stance of fiscal policy requires taking account of the activities of all levels of government

OBJECTIVES OF FISCAL POLICY 1. Stabilization Fiscal policy influences aggregate demand Directly because Y = C + I + G + X – Z Indirectly because C depends on income after tax Through demand, fiscal policy affects output, employment, inflation, balance of payments 2. Allocation Fiscal policy also influences aggregate supply Public infrastructure, education, health care 3. Distribution Through taxes, transfers, and expenditures Progressive, neutral, regressive

OBJECTIVES OF FISCAL POLICY Fiscal policy can be used to several ends To By adjusting aggregate demand to available supply By achieving low inflation, potential output To promote external balance By ensuring sustainable current account balance By reducing risk of external crisis To achieve internal balance promote economic growth E. g. , through more and better education and health care Fiscal policy needs to be coordinated with monetary, exchange rate, and structural – i. e. , supply-side – policies

STABILIZATION POLICY Demand management E. g. , lower income taxes Price level Aggregate supply in short run B A Aggregate demand Output

STABILIZATION POLICY Demand management Supply management E. g. , lower income taxes E. g. , lower import tariffs Price level Aggregate supply in short run B Aggregate supply in short run A A Aggregate demand Output B Aggregate demand Output

BASIC RELATIONSHIPS National income accounts Y =C+I+G+X–Z S = Y – T – C = I + G – T + X – Z, so G – T = S – I + Z – X Government budget deficit must be financed either by (a) having private saving in excess of private investment or (b) by accumulating foreign debt through a deficit in the current account of the balance of payments, or both Alternative formulation G – T = B + DG + DF Y = GDP C = Consumption I = Investment G = Government expenditure (plus lending minus repayments) T = Taxes (plus grants) X = Exports Z = Imports B = Government bonds outstanding DG = Credit from banking system DF = Credit from foreigners s. Inflationary v y finance r a n io t la f in n no Government budget deficit must be financed by borrowing either at home or abroad, i. e. , from (a) the public, (b) the banking system, or (c) foreigners

FISCAL POLICY AND INFLATION Central bank financing involves money creation Inflation tax: tax Most inflationary form of financing Bond finance is less inflationary Removes financial resources from circulation Increases real interest rates Crowds out private investment External financing can be inflationary Especially if it leads to currency depreciation Evidence from cross-country data Strong links between budget deficits and inflation in developing countries, but not in industrial countries Bond finance is the rule in industrial countries … … and money finance is the exception

FISCAL POSITION: ALTERNATIVE CONCEPTS Conventional budget surplus T –G Large in upswings when tax base (Y) is strong Small in downswings when tax base is weak Full-employment surplus TFE – G Use tax revenue as it would be at full employment Independent of business cycles A budget in deficit could be in surplus with full employment Deficit can be consistent with a tight fiscal stance (see chart) T, G not that Problem here is e but deficit is too larg o low that income is to sion Economic expan ally would automatic surplus, turn deficit into n from red to gree T G Y < YFE Y

FISCAL POSITION: ALTERNATIVE CONCEPTS Public sector borrowing requirement Broad measure of public sector deficit, including central, state, and local government Primary budget balance Leaves out interest payments Conventional deficit = G – T = GN + GI – T = GN + i. DG - T Primary deficit = GN – T = G – T – i. DG GN = Noninterest expenditure GI = Interest expenditure i = Nominal interest rate DG = Government debt outstanding

FISCAL POSITION: ALTERNATIVE CONCEPTS Operational deficit Leaves r≈i-p out inflation component of interest payments Operational deficit = conventional deficit minus inflation component of interest payments = primary deficit plus real component of interest payments GN = Noninterest expenditure Conventional deficit: GI = Interest expenditure N G G – T = G + i. D – T = G + (r + p)D – T r = Real interest rate DG = Government debt Operational deficit: p = Inflation rate G – T - p. DG = GN – T + r. DG Hence, operational deficit includes only real part of interest payments, leaves out the inflation part

USES OF FISCAL POLICY Before Great Depression 1929 -39, many thought that governments needed to balance their budgets from year to year Even so, US had built is railways through borrowing, for example Keynes revolted (General Theory 1936) If private sector failed to consume and invest, government could fill the gap Y = C + I + G + X – Z C and I and G appear side by side Guns or butter? Makes no difference Also, could reduce taxes to encourage C and I

USES OF FISCAL POLICY Multiplier analysis It could be shown that, with unemployed resources, an increase in G would raise Y by an amount greater than the original increase in G Active fiscal policy was used consciously in Sweden even before Keynes … … and adopted in US and elsewhere after 1960 (Kennedy-Johnson administration) Coincided with buildup of US as a welfare state with greater emphasis on public services and social security, like in Europe Active fiscal policy came naturally to Europe

USES OF FISCAL POLICY Fiscal policy can affect Aggregate demand, output, and price level Cut taxes: Consumption, output, and prices rise Rate of monetary expansion and inflation Increase spending financed by credit expansion: Money expands (M = D + R), R so inflation goes up Aggregate supply and economic growth Boost infrastructure, education, and health care: Efficiency and long-run growth go up Current account of balance of payments Raise taxes: Disposable income and imports fall, so current account improves unless currency appreciates

USES OF FISCAL POLICY Fiscal multipliers are positive, but small Impact of fiscal policy actions depends on Whether economy is open or closed (import leakage) Exchange rate regime (fixed or floating) Type of budget financing (money creation or debt) Degree of confidence in economic policy Level of government debt outstanding Financing constraints Risk premia on debt Whether fiscal changes are considered temporary or permanent How close the economy is to full employment n to Will retur this

FISCAL POLICY TRANSMISSION (-) Gov’t Budget Balance (+) RE (+) (-) Tax revenue (-) Consumption (+) Expenditure (+) Income (+) Fiscal Policy (-) (+) Interest Rate (-) Investment (+) Capital Labor

FISCAL AND MONETARY POLICY Monetary survey M =R+D D = D G + D P M = Money supply R = Reserves (NFA) D = Domestic credit (NDA) DG = Domestic credit to government DP = Domestic credit to private sector Fiscal policy determines government’s demand for bank financing (DG), which, in turn, affects total domestic credit (D), i. e. , net domestic assets (ignoring other items net), and money (M) Increased budget financing requires greater monetary expansion unless credit to private sector (DP) is cut or foreign reserves (R) go down, reflecting a weaker balance of payments position

FISCAL AND MONETARY POLICY In times of financial and economic crisis, fiscal policy plays key role in government’s response Fiscal policy played a role during Great Depression, even if theory behind it was poorly understood, or even disputed Fiscal policy plays key role in current crisis Monetary policy is ineffective if real interest rates cannot be reduced without igniting inflation Fiscal policy is more effective Massive fiscal stimulus in US, Europe, and Asia: it works! Fiscal stimulus is assisted by automatic stabilizers

FISCAL STIMULUS WITH FIXED EXCHANGE RATE REGIME Need for financing tends to lift interest rates, so capital flows in and currency tends to appreciate Central Bank must offset incipient appreciation by expanding money supply, thereby reinforcing initial fiscal stimulus Otherwise, exchange rate could not der n u s k r o remain fixed w s lu u Fiscal stim ates r e g n a h c x e d e ix f

FISCAL STIMULUS WITH FLOATING EXCHANGE RATE REGIME Need for financing tends to lift interest rates, so capital flows in and currency appreciates Appreciation reduces net exports, aggregate demand, and interest rates Process continues until interest rates d fall to their initial level But concerte s fiscal stimulu So, fiscal stimulus is ineffective can work even g with perfect capital mobility under floatin es exchange rat

FISCAL STIMULUS IN CRISES OF CONFIDENCE In times of large deficits and growing public debt, debt public spending can have weak or even negative effects By creating expectations of a fiscal crisis, crisis and hence of higher future taxes Increased saving may lead to a sharp fall in consumption Hence, fiscal stimulus can fail, and may even prove counterproductive Conversely, fiscal contraction may prove expansionary valence i u q e n a i d r a Ric

FISCAL POLICY AND BALANCE OF PAYMENTS Fiscal policy is frequently key to addressing balance of payments problems Simple mechanism M = R + D means R = M – DG – DP Hence, given M and DP, key to raising R is reducing DG IMF: It’s Mostly Fiscal!

FISCAL POLICY AND BALANCE OF PAYMENTS Or look at it this way: Y = C + I + G + X – Z means X–Z=Y–C–T–I–G+T=S–I+T-G Hence, current account balance (X – Z) Z equals sum of private sector surplus of saving over investment (S – I) I and government surplus of taxes over public expenditure (T – G) G Equivalently, Z – X = I – S + G – T means that external deficit equals sum of private sector deficit and government budget deficit

FISCAL POLICY AND BALANCE OF PAYMENTS Unsustainable fiscal policy can trigger a crisis if public loses confidence in government’s macroeconomic policy Sudden capital outflow can result, weakening the balance of payments and leading to a sharp devaluation Financing the budget externally builds up external debt, increasing risk of crisis Fiscal sustainability thus matters not only for debt, but also for balance of payments

FISCAL POLICY IN ACTION IN THE SHORT RUN Fiscal contraction (spending cuts, tax increases) can slow down inflation, reduce current account deficit Fiscal expansion (tax cuts, spending increases) can shrink unemployment, increase aggregate demand help restore output to full capacity, i. e. , bring actual GDP up to potential GDP, especially if monetary policy is impotent

AUTOMATIC STABILIZERS Automatic, or built-in, stabilizers are revenue or expenditure provisions that have counter-cyclical impact without need for policy intervention Protect against shocks Dampen business cycles Examples Progressive taxes on income, profits Price stabilization funds Unemployment insurance

GLOBAL FINANCIAL CRISIS AND FISCAL POLICY RESPONSE Monetary policy has been used heavily Its further impact may be limited In many countries, policy interest rates already approach zero Monetary policy may have limited effect during “balance sheet recessions, ” when many firms are technically bankrupt, will use increased earnings to restore capital, and may not respond to lower interest rates Koo (2009), Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession

GLOBAL FINANCIAL CRISIS AND FISCAL POLICY RESPONSE Mixed evidence on efficacy of fiscal policy in developing countries While automatic stabilizing impulses are weak and make the case for discretion, there is also the widely noted occurrence of pro-cyclicality That is, government spending tends to rise during booms and to fall during recessions

GLOBAL FINANCIAL CRISIS AND FISCAL POLICY RESPONSE The focus of stimulus packages differs between advanced and developing countries Infrastructure spending 46% of fiscal stimulus in developing economies, but 15% in advanced economies Tax cuts over 34% of fiscal stimulus in advanced economies, only 3% in developing economies Khatiwada, S. (2009), “Stimulus Packages to Counter Global Economic Crisis; A Review, ” International Institute for Labour Studies Discussion Paper 196.

GLOBAL FINANCIAL CRISIS AND ain g a s r FISCAL POLICY RESPONSE Multiplie No clear consensus among economists about the size of fiscal multipliers (response of real GDP to tax cuts or higher spending) Recent IMF Staff Position Note reports: q A rule of thumb is a multiplier (using the definition ΔY/ΔG and assuming a constant interest rate) of 1. 5 to 1 for spending multipliers in large countries, 1 to 0. 5 for medium sized countries, and 0. 5 or less for small open countries. q Smaller multipliers (about half of the above values) are likely for revenue and transfers while slightly larger multipliers might be expected from investment spending. q Negative multipliers are possible, especially if the fiscal stimulus weakens (or is perceived to weaken) fiscal sustainability. Source: Spilimbergo, Symansky, and Schindler (2009), “Fiscal Multipliers, ” IMF Staff Position Note spn/09/11.

FISCAL STIMULUS PLANS 2008 USD billion % of GDP Tax cut share (%) Brazil 9 0. 5 100 Canada 44 2. 8 45 China 204 4. 8 0 France 20 0. 7 6 Germany 130 3. 4 68 Japan 104 2. 2 30 India 6 0. 5 0 Korea 26 2. 7 17 Russia 30 1. 7 100 Spain 75 4. 5 37 UK 41 1. 5 73 US 841 5. 9 35 Source: Eswar Prasad and Isaac Sorkin (Brookings Institution, 2009) http: //www. brookings. edu/~/media/Files/rc/articles/2009/03_g 20_stimulus_prasad_table. pdf

KEY CONCEPTS q. Solvency § Having enough assets to cover liabilities, and ability to service debts in long run q. Liquidity § Ability to meet maturing obligations q. Sustainability § Solvency + liquidity + no expectation of unrealistically large adjustment q. Vulnerability § Risk of insolvency or illiquidity

STABILIZATION WORKED, OR WHAT? Change in Canada’s per capita GDP from year to year 1871 -2003 (%) 20 . next door? . S U e th t u o b a How 15 10 0 1871 1874 1877 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 5 -5 -10 -15 -20 bank Canada had no major Depression, t a re G g n ri u d s re u il fa its Deposit sh li b a st e t o n id d d n a until 1967 n o ti ra o rp o C e c n ra su In

0 -5 -10 -15 -20 -25 1871 1874 1877 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 on during Great Perhaps bank regulati abilize GDP st d e lp e h so al n io ss re Dep Change in US per capita GDP from year to year 1871 -2003 (%) STABILIZATION WORKED, OR WHAT? 20 15 10 5

on during Great Perhaps bank regulati abilize GDP st d e lp e h so al n io ss re Dep STABILIZATION WORKED, OR WHAT? Change in UK per capita GDP from year to year 1871 -2003 (%) 15 10 0 1831 1835 1839 1843 1847 1851 1855 1859 1863 1867 1871 1875 1879 1883 1887 1891 1895 1899 1903 1907 1911 1915 1919 1923 1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 5 -5 -10 -15 er capita p f o n o ti ia v e d rd a d n t sta Not quite as clear, bu. 8% 1947 -2003 1 to 5 4 9 -1 1 3 8 1 %. 1 3 growth fell from

0 -10 -20 1821 1825 1829 1833 1837 1841 1845 1849 1853 1857 1861 1865 1869 1873 1877 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 on during Great Perhaps bank regulati abilize GDP st d e lp e h so al n io ss re Dep Change in French per capita GDP from year to year 1821 -2003 (%) STABILIZATION WORKED, OR WHAT? 50 40 30 20 10

0 -10 -20 -30 -40 -50 1851 1854 1857 1860 1863 1866 1869 1872 1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 on during Great Perhaps bank regulati abilize GDP st d e lp e h so al n io ss re Dep Change in German per capita GDP from year to year 1851 -2003 (%) STABILIZATION WORKED, OR WHAT? 20 10

on during Great Perhaps bank regulati abilize GDP st d e lp e h so al n io ss re Dep STABILIZATION WORKED, OR WHAT? Change in Swedish per capita GDP from year to year 1821 -2003 (%) 10 0 1821 1825 1829 1833 1837 1841 1845 1849 1853 1857 1861 1865 1869 1873 1877 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 5 -5 -10 -15 Source: Maddison (2003).

LIMITS OF FISCAL POLICY Objections to fiscal activism Borrowing to finance increased government expenditures raises interest rates, thereby crowding out investment and reducing multiplier At full employment, increased public spending, however financed, leads to inflation without stimulating output except temporarily Increasing spending or cutting taxes to combat unemployment may impart inflation bias to economic system Rules vs. discretion Long lags, including approval and implementation Fiscal activism may tend to expand public sector

EXIT STRATEGY Fiscal stimulus packages need to include an exit strategy to ensure that solvency is not at risk, and should Not have permanent effects on budget deficits Provide a commitment to fiscal correction, once economic conditions improve Include structural reforms to enhance growth Should firmly commit to clear strategies for health care and pension reforms in countries facing demographic pressures

USES OF FISCAL POLICY Government has vital role to play in modern mixed economies (allocation role) Education Health care, cf. current debate in United States Infrastructure (roads, bridges, airports, etc. ) Some would also stress government’s distribution role … … claiming that the government should try to secure reasonable equality in the distribution of income and wealth, including poverty alleviation Normative or positive economics? Partly positive: Equality is good for growth

INEQUALITY AND GROWTH Two views Inequality sharpens incentives and thus helps growth Inequality endangers social cohesion and hurts growth 117 countries, 1960 -2000 r = -0. 27

INEQUALITY AND GROWTH Equality is good for growth No visible sign here that equality stands in the way of economic growth An increase in Gini index by 16 points goes along with a decrease in per capita growth by one percentage point per year r = -0. 27

USES OF FISCAL POLICY Why not raise government expenditure on public services or whatever and reduce taxes? – to buy votes Supposing all objections could be swept aside Because this would create a deficit and deficits can lead to inflation, inflation and inflation is undesirable for many reasons – it reduces efficiency and growth, for one thing Even so, a modest deficit can be sustained in a growing economy So how modest is modest?

PUBLIC DEBT DYNAMICS Debt accumulation is, by its nature, a dynamic phenomenon A large stock of debt involves high interest payments which, in turn, add to the deficit, which calls for further borrowing, and so on o Debt accumulation can develop into a vicious circle How do we know whether a given debt strategy will spin out of control or not? o To answer this, we need a little arithmetic

DEFICITS AND DEBT Revenues Expenditures Budget Deficit Financing Increase in debt Higher interest payments

PUBLIC DEBT DYNAMICS Recall operational budget deficit: G – T = B + DG + DF = D = GN + r. D - T where D is total government credit outstanding Further, assume for simplicity T = GN Then, we have D = r. D This gives

PUBLIC DEBT DYNAMICS So, now we have: Now subtract growth rate of output from both sides:

PUBLIC DEBT DYNAMICS But what is ? This is proportional change in debt ratio: This is an application of a simple rule of arithmetic: % (x/y) = % x - % y

PROOF z = x/y log(z) = log(x) – log(y) log(z) = log(x) - log(y) But what is log(z) ? So, we obtain Q. E. D.

DEBT, INTEREST, AND GROWTH We have shown that Debt ratio where as d e in ta s u s e b n a c s it Defic s not long as debt ratio doe e. , at i. – l o tr n o c f o t u o in p s least as long as g > r r g r=g r g Time

DEBT, INTEREST, AND GROWTH We have shown that Debt ratio where Need economic growth to keep debt ratio under control r g r=g r g Time

DEBT, INTEREST, AND GROWTH We have shown that Debt ratio where Higher interest rates can turn a sustainable debt position into an unsustainable one r g r=g r g Time

Primary deficit = GN – T = G – T – i. DG Primary balance: PB = T – G + i. DG DEBT, INTEREST, AND GROWTH Take another look Intertemporal budget constraint: Dividing by nominal GDP (= PY), we get e im t r e v o s e is r d , If r > g anged h c n u s in a m e r d If r = g, es If r < g, d declin

DEBT, INTEREST, AND GROWTH y Reducing primar deficit is key to o i t a r t b e d g n i c u red We have seen that To find where debt ratio is headed, i. e. , the long-run equilibrium value of d, we set dt = dt-1; this gives ary im r p t a h t s n a e pb < 0 m icit f e d in is e c n la a budget b > 0 if pb < 0 and g > r

FISCAL REFORM: REDUCING DEFICITS To improve primary balance Raise and reform revenue ü ü Raise taxes and fees Reform revenue collection by levying efficient taxes and fees ü ü E. g. , pollution fees rather than income taxes Improve tax administration Reduce and reform expenditure ü Emphasize efficiency ü Avoid waste

RAISING REVENUE: PILLARS OF TAX POLICY DESIGN Adequacy Taxes must be consistent with budgetary needs and with revenue generating capacity Simplicity Tax rules must be easy to understand entail low administrative and compliance costs Fairness Tax system must ensure that equals pay the same and rich pay more than poor Efficiency Tax policy must minimize distortions and disincentives

RAISING REVENUE: GENERAL TIPS FOR TAX DESIGN Broad base improves efficiency Limit Simple rates ease administration Use single or few preferably ad valorem rates Excessively high rates are ineffective Use holidays, exemptions, deductions, etc. moderate internationally comparable rates Pay attention to economic tax incidence Consider long-term consequences

RAISING REVENUE: DESIRABLE PROPERTIES OF TAX SYSTEM Revenue from broad-based sales tax Specifically, value added tax (VAT) Little reliance on trade taxes Simple personal income tax Corporate tax at single, low rate An elastic tax system

RAISING REVENUE: GENERAL GUIDELINES VAT Single rate of 10 -20% Few exemptions Trade taxes Low uniform tax on imports For protection, not revenue Avoid taxes on exports Income taxes No more than three brackets, Top marginal rate of no more than 40% Limited exemptions

RAISING REVENUE: GENERAL GUIDELINES Corporate tax Single proportional rate of 30 -40% Equalize top marginal rate of personal and corporate income taxes Prevents tax avoidance through choice of corporate or non-corporate form Few exemptions Elastic tax system Ensures that tax revenues will increase as economy grows

RAISING REVENUE: NUMBER OF COUNTRIES WITH VAT Early 1990's Americas Early 2000's 13 16 Sub-Saharan Africa 2 9 Central Europe and the BRO 1 14 Africa and the Middle East 3 5 Asia and the Pacific 4 11 Small Islands 0 2 23 57 Total number of developing countries with a VAT Source: Keen and Simone, 2004. 63

RAISING REVENUE: EFFECTIVE RATE OF TRADE TAXATION 1990 -91 2000 -01 Americas 4. 9 2. 2 Sub-Saharan Africa 9. 0 8. 1 Central Europe and BRO 4. 7 1. 5 North Africa and Middle East 5. 9 5. 7 Asia and Pacific 6. 3 2. 7 10. 1 8. 4 Developing countries 6. 5 4. 2 High-income countries 3. 1 1. 2 Small Islands Source: Keen and Simone, 2004. 64

RAISING REVENUE: STATUTORY RATES OF PERSONAL INCOME TAX Source: Keen and Simone, 2004.

RAISING REVENUE: CORPORATE TAX RATES 2000 (% OF GDP) Source: Keen and Simone, 2004.

RAISING REVENUE: REFORMING TAX ADMINISTRATION Essentials of Tax Administration Reform Explicit and sustained political commitment Team of capable officials Well-defined and appropriate strategy Relevant training for staff Adequate resources for tax administration Changes in incentives for taxpayers and tax administrators

REFORMING FISCAL POLICY: EXAMPLES United States Replace current income tax code by uniform flat tax or by national sales tax Europe Lower domestic tax rates to stimulate moribund economies Latin America and Asia Lower tariffs to improve competitiveness at home

REFORMING EXPENDITURE: PILLARS OF EXPENDITURE POLICY Compensate for market failure Externalities (education, health care) Public goods (national defense, air) Collective goods (fish) Social insurance Support private sector development Education Health care Infrastructure

REFORMING EXPENDITURE: PILLARS OF EXPENDITURE POLICY Affordability Level of public expenditure must be consistent with revenue and financing constraints Efficiency Appropriate mix of goods and services at lowest possible cost Priorities Expenditure priorities must be defined in accordance with economic goals Are expenditures productive? Equity In line with distributional objectives and poverty alleviation goals

REFORMING EXPENDITURE: KEY ITEMS OF EXPENDITURE Public wages and employment Provide adequate operations and maintenance spending Eliminate subsidies and target transfers Minimize military expenditure Encourage capital expenditures Eliminate unproductive spending

WAGES AND EMPLOYMENT General Average Ratio of government central public to employment as government private percent of total wage to per sector nonagricultural capita GDP wages employment Asia 3. 0 0. 8 56. 7 Eastern Europe and Central Asia 1. 3 0. 7 54. 6 Latin America and Caribbean 2. 5 0. 9 20. 9 Middle East and North Africa 3. 4 1. 3 53. 7 Sub-Saharan Africa 5. 7 1. 0 37. 8 OECD 1/ 1. 6 0. 9 23. 0 Sources: World Bank, ILO, and OECD. Data refer to 1996 - 2000 average. 72

REFORMING EXPENDITURE: UNPRODUCTIVE EXPENDITURE Identify white elephants Look for proximate indicators of misallocation Literacy rates Mortality rates Identify sectoral expenditure imbalances E. g. , high teacher/pupil ratio with inadequate teaching supplies Identify allocative inefficiency E. g. , generalized subsidies

REFORMING EXPENDITURE: GENERAL TIPS FOR ADJUSTMENT Avoid across-the-board cuts Be selective Target needed cuts Consider capacity for efficient project realization Focus on medium-term rather than one-shot measures Emphasize sound incentives, targeting, and transparency

REFORMING EXPENDITURE: FURTHER TIPS FOR ADJUSTMENT Address budget rigidity Address fiscal federalism Use fiscal policy to promote economic growth Long-run growth is endogenous, and responds to fiscal and monetary policy Monetary policy? Yes, because low inflation is good for economic growth

REFORMING EXPENDITURE: BUDGET RIGIDITY Many countries face budgetary problems from mandatory expenditures Creating automatic outlays, without needing formal approval by the government Examples Loan guarantees Public pensions, health insurance, jobless benefits Deposit insurance programs Tax expenditures Automatic reductions in tax liability for those with qualifying expenses

REFORMING EXPENDITURE: BUDGET RIGIDITY Challenge is to reduce pre-committed spending Some options are Limit tax expenditures Put ceilings or require minima on amount of expenses qualifying for deductibility from taxable income Reform Consider shifting to basic minimum benefit plus mandatory saving (defined contribution plan) U. K. (minimum benefit), Chile (more extensive reforms) Limit public pension programs loan guarantees and deposit insurance Insurance should not provide 100% coverage

REFORMING EXPENDITURE: FISCAL FEDERALISM Many countries allocate expenditure responsibilities to multiple levels of government Advantages May be more responsive to local needs Possibly better management Subsidiarity principle Disadvantage May be harder to control fiscal performance as a whole Challenge is to ensure adequate funding for services at all levels while achieving overall fiscal objectives

REFORMING EXPENDITURE: FISCAL FEDERALISM Different countries have different ways of maintaining discipline Balanced budget rules (common in US) Restrictions on borrowing by state and local governments (common in Brazil, India) Look for enforceability of restrictions and ability of subfederal units to evade limits

FISCAL POLICY FOR GROWTH IN THE LONG RUN Tax policy Consistent with investment-friendly business climate and adequate funding for government Expenditure policy Supply productive “public goods” Address externalities efficiently Restrict monopolies, promote competition Foster good governance, rule of law Provide financial regulation and safety nets Support private sector activity while focusing on those things that government can do better than private sector Avoid inflation, inefficiency, excessive inequality

TAX POLICY FOR GROWTH IN THE LONG RUN Creating an investment-friendly tax climate Moderate overall tax burden that allows financing efficient levels of government activity Focus taxes on consumption rather than income, to reduce double taxation of savings Modest income tax Limiting payroll tax burden Keeping corporate profit taxes modest Address double taxation of dividends Keep tax burden competitive with neighboring and comparable jurisdictions; may require moderating corporate profit tax rate

EXPENDITURE POLICY FOR GROWTH IN THE LONG RUN Be serious about stabilization, allocation, and distribution Keep spending consistent with revenue levels, to avoid heavy debt and debt service levels Build and maintain productive infrastructure Maintain effective education system Maintain cost-effective health care system Maintain impartial and effective courts Maintain appropriate regulatory environment, especially for financial sector and other sectors with important economy-wide externalities Also, encourage private sector

CONCLUSION THE END Sound fiscal policy is critical for good macroeconomic management, and can help manage capital flows Fiscal stimulus is usually expansionary, but not invariably Fiscal policy crucially affects BOP, and interacts with monetary policy Fiscal policy, as before, is crucial to responding to financial crises Especially when monetary policy lands in liquidity trap and loses traction Fiscal policy can help foster rapid growth