Guidelines for Fiscal Adjustment
How Much Fiscal Adjustment Is Required?
Fiscal adjustment policies should be designed within an overall methodological framework that links the implementation of a comprehensive set of policy measures to the achievement of the economy's objectives for inflation, growth, and external balance. Policy-setting within this framework requires decisions about the appropriate amount and form of fiscal adjustment, including the desired level of the fiscal deficit. A key link between the deficit and macroeconomic goals is through its financing. The use of bank credit, as well as nonbank domestic and foreign borrowing, to finance the government's operations must take account of the impact of each financing option on aggregate demand and prices, interest rates, the exchange rate, and the external balance.
A fiscal adjustment strategy may, in principle, require either a more restrictive or expansionary fiscal policy stance. Large structural deficits, rising government debt, and the need to address domestic and external constraints have emphasized the crucial importance of fiscal consolidation in many countries. The subsequent discussion largely focuses on such cases. However, there are also countries where domestic demand is weak and the underlying fiscal and external situation sufficiently strong, where fiscal stimulus may be appropriate.
This section considers the overall framework within which fiscal policies are formulated and some criteria for determining the amount of fiscal adjustment within this framework. Specific tax and expenditure strategies to achieve the required fiscal adjustment are reviewed in the following section on how fiscal adjustment should be effected.
A Framework for Fiscal Adjustment
For adjustment programs that qualify for financial support from the IMF, the methodological framework within which fiscal policies are designed is sometimes referred to as "financial programming." An essentially similar framework is used by policymakers for domestic policy formulation. Some key elements of a financial program are as follows:
- Objectives. The objectives of a financial program are usually specified in terms of the targets for growth, inflation, and the balance of payments position over the medium term. A sustainable current account in the balance of payments is considered as one that can be financed on a lasting basis with expected capital inflows and which, at the same time, is consistent with other macroeconomic targets and the country's ability to service its external debt obligations.
- Policy options. Four main types of policy options are usually considered:
(i) demand management: measures to affect domestic demand, including fiscal, monetary, and incomes policies, with a view to achieving the highest level of noninflationary output that is consistent with a sustainable external position;
(ii) expenditure switching: measures to provide incentives for external adjustment by changing the relative price of foreign and domestic goods, most obviously exchange rate policy;
(iii) structural measures: measures to increase potential output and facilitate a rapid growth in productivity (including encouragement of investment and savings, and reduction of allocative distortions that limit current output through their effects on allocative efficiency); and
(iv) financing: the attempt to attract a sufficient capital inflow to sustain a current account deficit without running into debt-service problems.
- Procedures. A financial program is formulated within a set of economic and financial accounts (including the national income and product accounts, the balance of payments, and the budgetary and monetary accounts), which provides a consistent framework for policy analysis. Policy formulation and forecasting require that the accounting framework be complemented by an understanding of key aggregate behavioral relationships in the economy. These allow policymakers to assess the reaction of the main macroeconomic aggregates to changes in key policy variables, for example, the impact of different levels of income and taxation on private sector spending.
- Uncertainties and choices. Behavioral relationships are often difficult to estimate, particularly when major policy shifts and structural reforms are being undertaken. Further, even if the direction of the effect of some policies is known with some confidence, the timing of their impact may be more uncertain. Policymakers face difficult choices with respect to the weight to be placed on different policy objectives (for example, supply-side measures to liberalize trade may result in an initial deterioration of the balance of payments). Choices may also exist in the use of policy instruments (such as the extent of reliance on demand restraint or exchange rate depreciation).
Determining the Amount of Fiscal Adjustment
The amount of fiscal adjustment needed is usually discussed in relation to the desired reduction in the overall fiscal deficit; often, possible trade-offs are suggested between the quantity and quality of adjustment measures.
Reducing the Fiscal Deficit
In general, when macroeconomic imbalances are pronounced, the need for fiscal adjustment is not in question. The desired amount of deficit reduction must be assessed in the context of overall macroeconomic policies and constraints. An issue that usually arises is the amount of reduction that is needed and the possible time period over which such adjustment can be achieved. Some more general factors affecting the required amount of deficit reduction are indicated below.17 In some circumstances, it may even be appropriate for a country to run a fiscal surplus (see Box 4).
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Box 4. When Should a Country Run a Fiscal Surplus? |
There are certain circumstances when the appropriate balance for a country is likely to be a surplus.
- To finance productive expenditure. When governments provide "lumpy" goods, for example, large investment projects, it makes sense to finance them through borrowing rather than by raising tax rates. This borrowing can then be repaid from a fiscal surplus when public spending is low. If the private sector has the capacity, but not the funds, to provide certain productive goods, the government can step in by on-lending funds it has borrowed, which, when repaid, may lead to a surplus; the government may also choose to run a surplus in order to increase savings available to the private sector through the capital market.
- To stabilize the economy
. To reduce inflation and/or the current account deficit, fiscal contraction is usually necessary and may imply a surplus. To dampen business cycles, governments can smooth aggregate demand over the cycle, which may imply a surplus during a boom. A negative supply shock (such as a drought), a positive demand shock (such as a property boom), or large capital inflows also justify a fiscal contraction, which may imply a surplus.
- To sustain the debt.
If government debt is unsustainable, a primary fiscal surplus will, in general, be necessary, and the debt problem may be so severe as to require an overall surplus. Indeed, a surplus itself may increase the sustainability of government policies by sending a highly visible signal to economic agents of the government's prudence.
- To build up wealth. When certain proceeds, such as mineral income, foreign grants, or privatization receipts, are exceptionally high, governments should save a portion for future use. To the extent that these receipts are classified as revenue, this may imply a surplus. Similarly, with an aging population, a PAYG (pay-as-you-go) pension scheme should run a surplus, which, if consolidated into the budget, may imply a fiscal surplus.
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- Cause and seriousness of imbalance. If analysis suggests that the root of a macroeconomic imbalance is a large fiscal deficit, it will need to be reduced (or eliminated). Where external sources of imbalance are of concern, such as may arise from a deterioration in the terms of trade, fiscal retrenchment may be required to complement external policy efforts--specifically, to ensure a real depreciation in the exchange rate when the nominal rate depreciates. Short-lived problems that are clearly self-correcting are less likely to require fiscal correction than more permanent imbalances. Policies to achieve a reduction in the fiscal deficit will be most urgent when the resulting macroeconomic problems are serious, and there is less scope for deficit financing.
- The needed reduction in the current account deficit. The section dealing with why fiscal adjustment may be needed presented a simple identity linking the fiscal deficit to the external current account deficit. As stressed there, the link between fiscal adjustment and achievement of a current account target requires consideration of the impact of fiscal policy on private sector saving and investment. This impact will depend on the mix of fiscal measures adopted and the accompanying stance of other macroeconomic policies. For example, fiscal restraint is far more likely to lead to current account adjustment if accompanied by an appropriate change in the real exchange rate.
- Debt dynamics and sustainability. A strategy for fiscal stabilization normally implies the targeting of a time path over which fiscal deficits will be reduced. The deficit that must be financed during this period will thus need to be serviced from future public sector resources. Although governments can borrow indefinitely, in the long run they must have the financial capacity to meet at least part of their interest costs without borrowing, namely, the primary balance should be in surplus. Otherwise, the level of debt will continually rise as a share of GDP. The only exception to this requirement is when the resources the government borrows are used so effectively that the economy's growth rate persistently exceeds the real interest rate on government debt; but this is unlikely, because when the growth rate exceeds the real interest rate, the increasing level of debt will push up interest rates, which, in turn, dampens growth.
- Financing. The determination of the required amount of adjustment may also be viewed by evaluating the appropriate level of financing items. Normally, adjustment programs seek to sharply curtail the rate of expansion of money and credit in order to reduce inflation. Given a growth in overall bank credit considered consistent with inflation and international reserve objectives, a limit may then be established on the amount of bank credit that can be provided to the government; this limit should ensure that adequate resources are available to finance the private sector. A ceiling may also be placed on government borrowing from abroad in order to ensure consistency with external and domestic debt-servicing capacity, respectively. Access to nonbank borrowing is often limited and again constrained by a desire not to "crowd out" private sector activity.
Quality of Adjustment
The required amount of fiscal adjustment is not independent of the quality of the specific measures chosen for its implementation. An assessment of quality would focus on the sustainability and the durability of the measures being considered and on the relative impact of alternative policy options on investment and production incentives as well as on the external account.
Specifically, short-term reduction of deficits through measures that cannot be sustained, or which may have adverse effects on growth over the medium term, should be viewed critically. Temporary surtaxes, tax amnesties, sales of public assets, and other measures may allow a country to stay within an agreed ceiling, but without doing anything to reduce its underlying deficit. Similarly, the postponement of essential operations and maintenance spending or inevitable wage increases, and even the deferral of payments, will be only of temporary value and may do more harm than good over the medium term. This argues for measures that are likely to be durable over the longer term, which do not diminish the efficiency of public sector operations and are the least costly in terms of their effects on growth in the rest of the economy.
Indeed, particular fiscal instruments may, over time, induce an important enough supply response in the economy to reduce the magnitude by which the deficit needs to be shrunk. For example, elimination of an export tax may, over the medium term, generate an expansion in output and export earnings, which increases revenue from other tax sources. Similarly, a policy to reduce employment in the public sector, especially in unprofitable public enterprises, may contribute to increased efficiency and lower costs in the medium term even though in the short-run fiscal deficits may increase due to the need for outlays on separation and unemployment benefits. Consequently, such measures need to be implemented as part of an overall policy package that provides for an appropriate degree of reduction of government absorption in the short run.
17 Analogous factors will affect the required amount of fiscal stimulus in countries where an increase in the deficit (or reduction in the surplus) is in order. However, in this case the emphasis is likely to be on the strength of the underlying fiscal and public debt position, the needed stimulus in domestic demand, and the desired adjustment in the external current account surplus.
