Speech

The Rewards of Virtue, Address by Anne O. Krueger, First Deputy Managing Director of the IMF

January 16, 2004

I'm delighted to be back in India, and to be at this conference. It is good to be among so many old friends.

This is an ambitious conference—and rightly so. It is tackling an important topic, and one that has particular significance for India. Economists and political leaders have for years paid lip service to the need for fiscal discipline. But governments—and here I am not referring specifically to India—have frequently discovered other, more pressing priorities. And to our collective embarrassment, economists have not always been fully seized of the importance of fiscal prudence.

Over time, however, debt levels have risen in India and elsewhere, and countries have faced the cumulative consequences of the failure to curb and then reduce public indebtedness.

I think that attitudes are changing, and I hope this conference will help focus minds both on the problems that need to be addressed, and on some appropriate means to address them. Given the distinguished line-up of speakers, it should easily succeed in doing that.

India is not alone in confronting a growing fiscal deficit. Nor is it alone in facing the prospect that fiscal imbalances could undermine recent economic progress. But that progress has been substantial—India was among the most rapidly-growing of the emerging market economies for most of the 1990s, for instance—and it would be a great pity if accelerating economic growth were retarded because of the lack of fiscal control and the consequent build-up of debt.

But my task today is an unusually easy one. I am not charged with presenting an analysis of the Indian situation, let alone offering policy prescriptions. There will be ample opportunity for that over the next two days. This morning, I simply want to welcome you; to thank you for your participation; and, briefly, to place the discussion of the next two days in a broader global context. That seems appropriate in a country that is now one of the leaders of the developing world, and which is, in so many ways, beginning to reap the benefits of its reforms and of global integration.

The importance of sound fiscal policies

I would disappoint you if I did not say that the IMF attaches great importance of sound fiscal policies. We do. We believe they are an essential component of macroeconomic stability.

But we believe macroeconomic stability is vital for achieving sustainable rapid growth and the opportunities for poverty reduction that flow from that.

Effective fiscal reform need not be a painful and unpopular exercise in austerity. In fact, fiscal policy can make a substantial positive contribution to growth and poverty reduction. It can do so by freeing up scarce economic resources; by introducing appropriate liberalization; and by creating the right incentive signals, including the reduction of deadweight losses that less distorting tax structures can bring.

That does not mean, of course, that difficult choices aren't necessary. They certainly are, as any finance minister will attest!

But let me emphasize that the choices that fiscal reform entails are essentially political. When it comes to deciding whether to focus on cutting spending, raising taxes, or reforming tax structures—or some combination of all these: the choice is one for national political leaders. It is what they were elected to decide.

The same goes for new, high-priority, public expenditures; reducing current (inefficient and low-priority) expenditures; more public investment and/or raising taxes. These are all political choices.

Where the Fund can perhaps be particularly helpful is in clarifying the alternative means available to governments to achieve the objectives they have set for themselves. We can give guidance about which options will best meet governments' needs—guidance based on long and wide experience in many countries. The Fund—and in this context, I'm thinking particularly of our Fiscal Affairs department—works hard to develop in-house expertise that incorporates both our own experience and the latest academic research. The IMF has always been a learning institution, and the Independent Evaluation Office, established in 2001, has played an important part in helping us to be more effective in implementing what we have learned.

Successful fiscal reform

As I said a moment ago, I am not going to offer detailed policy prescriptions. But I do want to make some observations about what successful fiscal reform includes.

I start from the premise that successful economic performance is most likely to be achieved by letting the market decide, whenever possible, on how best to allocate resources. Government has an important role, of course, and different countries can—legitimately—take different views of how great that role should be. In emerging market economies, for instance, there is often a need for substantial infrastructure investment that both helps generate and is made more urgent by rapid economic growth. All too often, the growth prospects of developing economies have been hampered by inadequate infrastructure, supply bottlenecks and distribution problems.

In all countries, though, society has taken the view that some public investment is appropriate in the case of public goods.

Much more important than the actual size of the public sector is the need to ensure that it operates efficiently. Government policies should create a level playing field, so that proper market incentives can operate when possible. That means a tax system that minimizes distortion, and does not arbitrarily favor one sector of the economy over another. It means letting the market make decisions about most investment. And it means that in both current and capital spending, governments should seek to avoid waste and inefficiency that could crowd out more productive use of resources.

Making public sector expenditures more efficient can free up resources across the whole economy, making it possible for the government to do more with less. And if that sounds like having your cake and eating—well, it is, to a considerable extent!

A more efficient public sector involves more efficient revenue collection and the adoption of broader-based taxes. If tax evasion is reduced, and the tax base widened, tax rates can be lower for any given revenue need—and harmful distortions can be reduced.

An efficient civil service cuts the wage bill for any given level of government activity. And it frees up often vital labor skills needed in other sectors of the economy.

Targeting transfer payments more directly can enable the government to cut the total bill while providing more generous benefits to those most in need.

Sometimes the steps that need to be taken are obvious, if not entirely painless. Brazil, for instance, is a country that has made great progress in its efforts to establish the public finances on a sound footing. It is emerging from last year's financial turmoil and is beginning to reap the benefits of its tough fiscal commitment: Brazil's standing in the financial markets has been greatly enhanced, the interest rate paid by the Brazilian government on its debt is sharply lower, and there are important signs that growth is now accelerating.

The government has begun to tackle the problems created by overly generous—and under-funded—provision of public sector pensions. Hitherto, Brazilian public servants had enviable retirement benefits, enabling them, for instance, to retire on full pensions much earlier than their private sector counterparts. They have been able to enjoy far higher pensions although their contributions were generally lower than private sector pension schemes. The problem grew so large that it could not be ignored: the cash deficit on public pensions was around 5% of GDP. By starting to tackle this—by raising retirement ages, for instance—the government is able to free up significant resources that can be used to meet other, more pressing—and dare I say more deserving—needs.

In other instances, the problem stems from a failure to follow-through. In the early 1980s, Turkey's ambitious reform program was subsequently undermined because of the failure to bring some elements of public spending under control. In 1980, the Turkish government eliminated price controls on a wide range of state owned enterprises, and put in place tougher budget constraints. The public sector deficit fell by about 8% of GDP. Supply shortages disappeared and growth accelerated. But at the same time, the government was losing control of important off-budget expenditures. As the deficits of these units soared, so too did inflation, creating an economic environment that led to the crises of the 1990s.

Federal budgetary systems bring especially difficult challenges. It is sometimes forgotten that in the 1990s, Argentina made significant economic progress on a wide range of issues. But the complicated financial relations between the federal government and the provinces crucially undermined attempts at fiscal control. Under the existing arrangements, the provinces had little incentive to control their spending.

A systematic process

But as Turkey's experience showed, it is not enough to introduce one or more reforms. Consistency of purpose—or the lack of it—has been the fatal flaw in so many reform programs in the past. "Reform fatigue" can sometimes simply mean those in charge have lost the momentum needed to drive through ambitious change. It is perhaps rare that governments decide that they have done enough for the time being. More commonly, they become pre-occupied with short term problems that distract them from longer term structural reform.

Reform, though, is a process, not a step: it has to be ongoing, because economies must constantly adapt to change. And achieving fiscal discipline is part of that continuing process, for the same reason. As economies change, so do their structures; and so, in turn, does the structure of public finances. Spending needs and obligations alter, and revenues fluctuate. The rapid build up of unfunded public pension obligations, for instance, can alter the outlook for the public finances in a quite dramatic way in a relatively short time. The problem of projected revenues that fail to materialize is one familiar to many finance ministers and their officials.

And partial reforms are often less than partially successful. Tackling one sector of the economy without confronting the need for structural change in another area will mean that the total result is less than the sum of its parts. Conversely, ambitious, comprehensive reform will deliver far greater returns. One only has to look at the example of Korea to see what rewards consistency and ambition can bring.

From the late 1950s onwards, Korea undertook a series of wide-ranging reforms aimed at transforming itself into a fully-fledged market economy. Part of the impetus for this was the prospect of declining American financial aid. But the reforms systematically addressed fundamental problems. Tax policy was reformed and tax collection improved. Public spending was brought under control and high tariffs reduced. The huge budget deficits—bigger even than American aid, itself more than 10% of GDP—were virtually eliminated in just a few years.

I don't have to remind you about the results of Korea's reform efforts. Economic growth was spectacular, especially in the 1960s and early 1970s. GDP per capita rose seven fold in the three decades to 1995, and eleven fold between 1962 and 1992. It is a performance of which any country would be proud.

Putting the public finances in order was a crucial step in the process, and enhanced the returns to other reforms as well.

Seize the moment

There is, of course, never an easy time to engage in fiscal reform. But there are times when doing so is significantly easier than others. The world economy is now clearly on the upswing. Recovery in the United States is stronger than we had anticipated, and the outlook for many regions of the world—including Asia—is brighter than it has been for some time. International security concerns have begun to ease a little.

Of course, a benign outlook tends to reduce the sense of urgency when it comes to tackling the problem of fiscal imbalances. But that is precisely when it makes most sense to act—when there is a real chance to move away from pro-cyclical policies. Postponing difficult decisions doesn't make them go away—it just makes them more difficult. India has already embarked on economic and fiscal reform. It would be a pity to lose the momentum and not take advantage of high growth.

Globally, rising levels of public debt in emerging market economies represent, in the IMF's judgment, one of the biggest risks to the prospect for accelerating growth. Faster growth is essential for poverty reduction in the developing world. Fiscal imbalances aren't the only impediment, of course. But reducing public debt levels and the adoption of sound fiscal policies are both necessary conditions if economic ambitions are to be realized.

Thank you