Speech

The Quality of Fiscal Adjustment, Remarks by Rodrigo de Rato, Managing Director of the International Monetary Fund

June 12, 2005

Mr. Prime Minister, ladies and gentlemen, thank you very much indeed for your kind introduction.

It is a great pleasure to be here. The IMF works closely with all the countries in this grouping, and I am delighted to have the opportunity to meet with you today. As you know, a key part of the IMF's work involves helping countries put in place sound macroeconomic and financial policies. Strengthening fiscal policy is often a key part of any adjustment strategy. In my remarks today, I would like to focus on what makes fiscal adjustment successful. In particular, I would like to talk not about size, but about quality. Not about how much adjustment is needed, but how to adjust well, in order to achieve policy goals with maximum efficiency and minimum welfare cost.

There is nothing new about emphasizing the importance of the quality of fiscal adjustment. The key role played by the composition of measures in ensuring successful adjustment is supported by empirical evidence from a broad range of countries. For instance, according to a recent study by the European Commission, the composition of fiscal consolidation is the most significant explanatory variable for determining whether such consolidations foster higher growth. Recent IMF research on large fiscal adjustments confirms these findings for a wider range of countries.

I also speak from personal experience with Spain's adjustment strategy in the late 1990s, when the economy grew vigorously even in the midst of fiscal retrenchment. The success of this consolidation was largely the result of its focus on structural cuts in current primary spending which, in turn, paved the way for substantial interest savings. The basic principle was to contain current expenditure, while protecting public investment to ensure full use of EU assistance. At the same time, the commitment to fiscal discipline was anchored in a solid institutional framework.

When it comes to the choice of measures that can help make fiscal adjustment successful, there isn't, again, a one-size-fits-all prescription. Coming from the head of the IMF, this may strike you as a surprising statement, since we are frequently criticized for recommending fiscal contraction as a remedy for almost every economic ill. Yet, the truth of the matter is this—like all policy areas, what is required by each country in fiscal policy depends on the unique circumstances of that country. Some economic programs that we have supported even targeted increasing fiscal deficits.

What is clear, however, is that fiscal adjustment is more likely to be successful when it is supported by measures perceived by markets and the population at large as durable and sustainable. By boosting confidence, these measures are more likely to contribute to long-term growth and development than lower-quality quick fixes.

But, in reality, as you and I know, policymakers face constraints that can preclude smooth and timely implementation of high-quality reforms. This may be especially true when there is a need for an immediate fiscal tightening to avert an impending crisis. In such cases, policy makers may opt for quick fixes.

Short-term measures

Quick fixes are the crash diets of fiscal adjustment. These are measures that can be implemented quickly and yield predictable savings, at least initially, but are typically low-quality and damaging over time. Popular examples include financial transactions taxes, tax amnesties, export surcharges, and across-the-board spending cuts. And like crash diets, they are not the best way to lose weight. Let me say a few words about each of these examples.

• First, financial transactions taxes—these taxes, especially when levied at high rates, can drive financial transactions underground. Fewer financial transactions result in falling revenue yields, the economy loses productivity, and the banking system suffers.

• Second, tax amnesties—repeated tax amnesties erode taxpayers' incentives to comply with tax laws, and damage the credibility of tax authorities. Not only do they result in lower revenues over the longer term, their benefits typically accrue to the better off in society.

• Third, export surcharges—these undermine the competitiveness of the critical export sector, reduce the country's access to foreign exchange, and weaken growth.

• Finally, across-the-board spending cuts—while these cuts can curb expenditure and the deficit in the short run, they tend to have significant efficiency costs over the longer term, and may lead to an accumulation of arrears.

Quite apart from the negative effects of these quick fixes, one should bear in mind that short-term fixes cannot replace high-quality fiscal measures, and should not be seen as permanent solutions. Even though these measures can temporarily reduce the deficit, they are typically harmful in the long run because they create powerful economic distortions. What's more, their yields tend to decline over time.

This was the case for instance in Macedonia, when it introduced a financial transactions tax to cope with the exceptional costs of the security crisis in 2001. While policymakers recognized the shortcomings of the tax, they saw it as unavoidable if the fiscal deficit were to be kept to a manageable level in the short run. However, once public expenditure and the deficit were under control, the financial transactions tax was replaced with more efficient revenue sources, including a broad-based value added tax.

And so on quick fixes, the moral of the story is to avoid them. But if you can't, replace them quickly with better quality measures, which are the equivalent of a balanced diet and exercise.

Durable reforms

Just as a balanced diet and exercise help people to lose weight and keep it off, the empirical evidence shows that growth and unemployment respond more favorably to longer-lasting, better-quality, fiscal adjustment. Durable reforms signal that the adjustment effort is sustainable, thereby strengthening the credibility of government policies and altering people's behavior.

Taxation

When it comes to durable revenue reform, international experience suggests that the most promising measures focus on expanding the tax base. Eliminating exemptions and tax incentives contributes to the overall efficiency of the tax system and also improves revenue productivity. This can create room for cutting rates. For example, Bulgaria recently eliminated many tax exemptions and all preferential VAT rates, allowing it to lower direct taxes. Croatia also successfully replaced a complicated, multi-rate sales tax system with a broad-based VAT.

Tax exemptions and incentives are common. They are often defended as needed to attract foreign investment. But experience and evidence show that tax incentives are not the best instrument to attract genuine long-term investment. This is because they cannot make up for serious deficiencies in other factors affecting a country's investment climate, such as macroeconomic stability, the regulatory environment, and the quality of financial systems. At the same time, they prevent countries from establishing broad-based, equitable and simple-to-administer tax systems. Further, the costs associated with these incentives can be large and are typically not made explicit in government budgets. Often these incentives also lead to abuse and corruption, and complicate tax administration.

The so-called "flat tax" has become a popular revenue reform. In Europe, it comes in various forms, but the idea of low-rate simple taxes has much to commend it. Estonia led the way, replacing three tax rates on personal income, and another on corporate profits, with one uniform rate of 26 percent. It has since been followed by eight others in Europe, including Russia, and in this constituency, Georgia, Romania, and Ukraine, with personal income tax rates in the low teens. Low, single, rates can clearly encourage compliance and reduce complexity. And following its introduction in Russia in 2001, revenue from the personal income tax also boomed.

However, a recent study of this Russian reform by IMF staff, done in collaboration with outside experts, highlights three points about flattening tax structures which merit closer attention:

• Simplicity is more than just a matter of the rate structure—much of the complexity, and the scope for corruption, stems from definition of the tax base.

• Combined with administrative improvements, reducing and flattening tax rates can strengthen compliance.

• However, it is generally unlikely that tax rate cuts would pay for themselves.

Public expenditure

Improving the composition of public expenditure is also critical for delivering durable and high-quality fiscal adjustment. Channeling resources to more productive uses contributes to long-term economic growth and development by addressing common market failures. Durable cuts in unproductive spending can increase the likelihood of an expansionary fiscal contraction by boosting market confidence and fostering the credibility of a sustainable fiscal adjustment.

Empirical evidence suggests that productivity of government expenditure is more important than its size in ensuring sustainable growth and development. It is essential to redirect government expenditures towards uses with the highest social return. Ultimately, the optimal composition of public investment is country-specific and depends on many factors, including the level of economic development and the strength of regulatory frameworks and institutions for managing investment projects.

This principle is echoed in the EU's Lisbon strategy, which calls for redirecting public expenditure toward growth-enhancing, cost-effective, investment in physical and human capital, and knowledge. And indeed, the evidence of the last few years indicates that many EU member states have been changing their expenditure composition toward these more productive uses.

The productivity of public investment, in turn, depends critically on the quality of projects. A recent study of some eight pilot countries conducted by the IMF suggests that many countries can substantially improve the quality of their infrastructure spending through better evaluation, prioritization, and management. Further, for additional investment to contribute to growth and development, its financing needs to be consistent with macroeconomic stability and debt sustainability. This is especially important for countries, such as Armenia and Georgia, which face the challenge of managing large external inflows.

Balancing high social spending with other current expenditure is also a common challenge for many EU accession countries. A wide range of studies shows that durable expenditure adjustment typically involves tackling the wage bill, pensions, and other social transfers. Reforms in these often politically sensitive areas can reduce budget rigidities and improve the ability of fiscal policy to react to the economic cycle.

Public expenditure composition can also be improved by enhancing the performance of public enterprises. This not only produces fiscal savings, but also increases efficiency. Some of the largest losses, which are often hidden, occur in the energy sector, and this has been a focus of fiscal adjustment for many of the countries in this constituency. Armenia and Ukraine, for example, have successfully reduced their large quasi-fiscal energy sector deficits.

Social safety nets

While fiscal consolidations can, especially if well-designed, spur growth, they often result in some short-term output and social costs. So a well-designed adjustment strategy needs to incorporate targeted social programs to mitigate any adverse impact of economic reform on the poor and the vulnerable.

Some countries may find it challenging to achieve a balance between addressing pressing social needs and maintaining fiscal restraint to meet macroeconomic objectives. Moldova, one of the poorest regions in Europe, is a case in point. In cases like Moldova's, good targeting of social programs that minimizes leakages to the better off becomes especially important.

Fiscal institutions

Let me turn now to institutional reform more broadly. Without well-functioning fiscal institutions, even the best designed policy measures may fail. Good fiscal institutions, such as sound, transparent, and efficient budget systems, fiscal responsibility frameworks, and effective revenue administrations, can greatly facilitate adjustment.

Fiscal transparency enforces accountability and helps promote broad public support for fiscal reforms. Greater transparency can also help in identifying higher quality adjustment measures. For instance, the transparent publication of the costs of tax exemptions in the Ukrainian budget helped secure support, from both policymakers and the general public, for reducing these exemptions. In recognition of these benefits, the IMF has been helping countries improve their fiscal transparency frameworks, including through assessments and technical assistance based on our Code of Good Practices on Fiscal Transparency. Since 1999, 74 fiscal transparency assessments have been completed, and most of them can be viewed on our web site.

Like flat taxes, fiscal responsibility frameworks have become popular instruments of institutional reform in recent years. Here, those frameworks that focus on procedures, and are backed by sound budget systems, can indeed be useful in promoting fiscal discipline and strengthening the credibility of fiscal policy. Frameworks based on strict numerical rules, such as balanced budget requirements, have a more mixed track record, and underline the critical importance of political will to comply with the rules.

Effective implementation of policies is as important as the design of the policies themselves, and tax policies are no exception. No matter how good in theory, they cannot be successfully implemented without a solid tax administration. This means, for example: organizing tax administrations by function, such as audit and taxpayer assistance, rather than by tax; basing payment and collection on the principles of voluntary compliance and self-assessment, reinforced by selective risk-based audit; and, giving special attention to large taxpayers, for example, through a dedicated large taxpayer office, as the one recently established in Armenia.

On the expenditure side, policy measures need to be supported by an effective budget management system. Such a system is key for ensuring effective spending control, improving financial management, and achieving cost-effectiveness in service delivery. An IMF study based on a wide range of low and middle income countries concludes that countries with sound budget management systems were more successful in protecting expenditure with high social rates of return. Similarly, recent research on expenditure composition in EU-member countries suggests that countries with stronger medium-term expenditure frameworks are more successful in steering the composition of public expenditure towards more productive uses. In line with these trends, a number of countries in this constituency, including Armenia and Georgia, have been focusing on developing such frameworks.

Concluding remarks

To sum up, there are many ways to effect fiscal adjustment. None of them are easy. Sometimes quick fixes are unavoidable. But they should not become entrenched and should be replaced with higher-quality measures to ensure long-lasting fiscal impact and sustainable growth. Ultimately, the quality of fiscal adjustment is only as good as the quality of the fiscal measures and institutions that underpin it. The importance of building strong and dynamic fiscal institutions should therefore not be overlooked.

Lastly, the individual circumstances of each country would, of course, dictate what adjustment measures are required. On our part, the IMF stands ready to offer its advice and assistance to countries seeking to put in place sound fiscal policies and lay the foundation for a strong economy.

Thank you very much.