A quarterly magazine of the IMF

June 2005, Volume 42, Number 2

Back to Basics -- Fiscal Space: What It Is and How to Get It

Peter Heller

"Fiscal space" is a term that has recently become fashionable in the aid community. But what it means is fuzzy. Sometimes, the concept has cropped up when governments have argued that fiscal constraints should be relaxed to accommodate additional borrowing to finance infrastructure projects. The logic is that these projects create productive assets that pay for themselves over the long term, thus creating the fiscal space that they need. But recently, the term has also been used by advocates of higher health and education outlays who have argued that these expenditures will eventually pay for themselves through higher returns to human capital. Although the term is new, the concept is not. It has long been an element of sound fiscal analysis. And the challenge of creating fiscal space is one that has always confronted governments and their advisors, including international financial institutions like the IMF.

Defining fiscal space

What is fiscal space? It can be defined as room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy. The idea is that fiscal space must exist or be created if extra resources are to be made available for worthwhile government spending. A government can create fiscal space by raising taxes, securing outside grants, cutting lower priority expenditure, borrowing resources (from citizens or foreign lenders), or borrowing from the banking system (and thereby expanding the money supply). But it must do this without compromising macroeconomic stability and fiscal sustainability—making sure that it has the capacity in the short term and the longer term to finance its desired expenditure programs as well as to service its debt.

How can this be done? The government must ensure that the higher expenditure in the short term, and any associated future expenditure—including any recurrent spending on operations and maintenance required by an infrastructure investment, or by the establishment of a school or hospital—can be financed from current and future revenues. If debt-financed, the expenditure should be assessed by reference to its effects on the underlying growth rate and the country´s revenue-generating capacity. The government needs to be sure, in particular, that increased outlays in one worthwhile area—health, for example—will not ultimately crowd out productive spending elsewhere.

For developing and emerging market countries, fiscal space may seem a more immediate issue than in advanced economies because there are more pressing needs for expenditure today. But longer-term issues are also involved, even for lower-income countries, because of the need to ensure that there will be room to respond to unanticipated fiscal challenges. For example:

• Countries that receive significant flows of foreign resources for a specific sector (such as health care) may, as a result of the associated expansion of the sector, face additional future spending needs that may essentially preempt a share of the growth of future domestic budgetary resources.
  
  
• Foreign resource inflows, such as aid, may hurt a country´s macroeconomic situation (for example, by raising its real exchange rate and thus reducing its international competitiveness) or cause excessive aid dependency, so that such inflows may need to be limited. A foreign-financed expansion of a specific sector (for example, education) may then imply limits on the magnitude of foreign resources available to other sectors.
  
  
• Resource inflows may finance a government activity, such as pension reform, that creates a liability in the form of future payouts that are highly uncertain in magnitude and timing.

The IMF´s approach

What is the IMF´s stance? When the IMF evaluates a country´s macroeconomic situation, it is open to the creation of fiscal space through higher foreign grant inflows for spending on infrastructure or social programs. But the IMF would flag a concern if the higher spending jeopardized macroeconomic stability or debt sustainability. Such caution particularly extends to the use of central bank credit, given the IMF´s concern with inflation and its damaging effects on growth and poverty. Moreover, higher spending in a sector, even if financed from external grant flows, may have implications for other sectors that will need to be taken into account.

How is potential fiscal space determined? The IMF looks at both the scope for greater public saving through expenditure rationalization and tax reform, and the extra resources that can be mobilized from borrowing and grants. It also appraises underlying factors that affect the outcome of government policies.

Reprioritizing expenditure. Curbing unproductive spending should be an important objective. This may require cuts in subsidies or military outlays, wage restraint, or rationalization of elements of the civil service (including by tackling the common problem of ghost workers). But at the same time, productive spending needs to be protected: not spending enough on a sector (say, health) can have damaging social effects and prove to be a false economy, raising future spending requirements by weakening the sector so much that it would be costly and time consuming to "rebuild" it.

Boosting efficiency. Other aims should be to streamline the implementation of programs, reduce corruption, and improve governance. Donors can help by paring conditionality, eliminating aid-tying, reducing administrative overheads, better coordinating spending in a sector, and reducing the administrative overload imposed on the limited number of recipient country program managers.

Raising revenue. For countries with low ratios of government revenue to GDP, broadening the tax base and improving tax administration are likely to be important objectives. For low-income countries, a tax ratio of 15 percent of GDP should be seen as a minimum objective.

Increasing borrowing. Given that domestic and foreign borrowing must be serviced and repaid, policymakers need to evaluate whether the social return from the uses to which the borrowing is put justifies the cost. Governments may choose to borrow without taking specific account of the direct returns, but then must do so when assessing the overall sustainability of a program. Such assessments typically weigh an economy´s prospective growth rate, potential for exports and remittances, prospective interest rate environment, revenue elasticities, composition of existing debt (in terms of interest rates, maturity, and currency of borrowing), and terms of new debt being considered.

Monetary expansion. This is not a desirable option! A government´s borrowing from the banking system should be driven by monetary policy objectives—namely, the creation of sufficient liquidity to support an economy´s real growth, with no more than low inflation. Even if a government were explicitly to rely on money creation to facilitate somewhat higher government expenditure, there are clear limits, given the potential inflationary impact.

Securing more external grants. For many developing countries, this is increasingly feasible given the global commitment to help countries reach the Millennium Development Goals (MDGs). Grants can clearly provide more fiscal space than borrowing, where debt sustainability considerations have to be taken into account even when loans are highly concessional. But only a sustained and predictable flow of grants can create the potential for a scaling up of expenditure that can be maintained, and reduce the uncertainty as to whether a grant is simply of a one-time nature. (See Back to Basics in F&D, December 2004). And countries will need to take account of the potential macroeconomic consequences in terms of international competitiveness that may arise from a signficant scaling up in absorption of external resource inflows.

Pursuing sound macroeconomic policies. Delays in completing IMF program reviews or cessation of IMF-supported programs—which often results from a country´s failure to implement agreed macroeconomic policies—can affect assistance from other lenders and donors, and result in volatile flows. Countries that manage policies well are likely to have greater potential for creating extra fiscal space. Governments need to clarify with donors the likely availability of foreign assistance over the medium to long term and structure their expenditure programs accordingly.

In sum, the fiscal space debate has proven useful, reflecting the importance of clarifying ways to facilitate expanded spending by governments to foster growth through higher infrastructure spending and to finance programs vital to the achievement of the MDGs, particularly those related to HIV/AIDS. And the IMF is committed to working with countries to explore the scope for expanded fiscal space.