fiscal policy

1
fiscal policy

• Thorvaldur Gylfason
• IMF Institute/Center for Excellence in Finance,
  Slovenia
• Course on Macroeconomic Management and Financial
  Sector Issues
• Ljubljana, Slovenia
• September 2129, 2011

2
outline

• Objectives and uses of fiscal policy
• Stabilization, allocation, distribution
• 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
• Fiscal reforms

3
definition of fiscal policy

• The term fiscal policy refers to the use of
  public finance instruments to influence the
  working of the economic system to maximize
  economic welfare
• Effects of fiscal policy reflect not only the
  impact of the fiscal balance, but also various
  elements of taxation, spending, and budget
  financing
• Assessing the stance of fiscal policy requires
  taking account of the activities of all levels of
  government

Vito Tanzi
4
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
• Allocation
• Fiscal policy also influences aggregate supply
• Public infrastructure, education, health care
• Distribution
• Through taxes, transfers, and expenditures
• Progressive, neutral, regressive

5
Objectives of fiscal policy

• Fiscal policy can be used to several ends
• To achieve internal balance
• 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 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

6
Stabilization policy

• Demand management
• E.g., lower income taxes

Aggregate supply in short run
B
Price level
A
Aggregate demand
Output
7
Stabilization policy

• Demand management
• E.g., lower income taxes

• Supply management
• E.g., lower import tariffs

Aggregate supply in short run
Aggregate supply in short run
B
Price level
Price level
A
A
Aggregate demand
Aggregate demand
B
Output
Output
8
Basic relationships
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

• 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
• 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

Inflationary vs. noninflationary finance
9
Fiscal policy and inflation

• Central bank financing involves money creation
• Inflation 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

10
Fiscal positionAlternative 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 beat full employment
• Independent of business cycles
• A budget in deficit could be insurplus with full
  employment
• Deficit can be consistent with a tight fiscal
  stance (see chart)

Problem here is not that deficit is too large but
that income is too low Economic expansion would
automatically turn deficit into surplus, from red
to green
T, G
T
G
YFE
Y
Y lt YFE
11
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
  iDG - T
• Primary deficit GN T G T iDG

GN Noninterest expenditure GI Interest
expenditure i Nominal interest rate DG
Government debt outstanding
12
Fiscal position Alternative concepts
r i - p

• Operational deficit
• Leaves out inflation component of interest
  payments
• Operational deficit conventional deficit minus
  inflation component of interest payments
  primary deficit plus real component of interest
  payments
• Conventional deficit
• G T GN iDG T GN (r p)DG T
• Operational deficit
• G T - pDG GN T rDG
• Hence, operational deficit includes only real
  part of interest payments, leaves out the
  inflation part

GN Noninterest expenditure GI Interest
expenditure r Real interest rate DG
Government debt p Inflation rate
13
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

14
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

15
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), 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

16
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

Will return to this
17
fiscal policy transmission
(-)
RE ()
(-)
Govt Budget Balance
Consumption
()
()
(-)
()
()
()
Tax revenue
Expenditure
Income
Interest Rate
(-)
()
Investment
Fiscal Policy
(-)
()
Capital
()
Labor
18
fiscal and monetary policy
M Money supply R Reserves (NFA) D Domestic
credit (NDA) DG Domestic credit to
government DP Domestic credit to private sector

• Monetary survey
• M R D
• D DG DP
• Fiscal policy determines governments 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

19
fiscal and monetary policy

• In times of financial and economic crisis, fiscal
  policy plays key role in governments 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

20
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 remain fixed

Fiscal stimulus works under fixed exchange rates
21
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 fall to
  their initial level
• So, fiscal stimulus is ineffective with
  perfect capital mobility

But concerted fiscal stimulus can work even under
floating exchange rates
22
Fiscal Stimulus in crises of confidence

• In times of large deficits and growing public
  debt, public spending can have weak or even
  negative effects
• By creating expectations of a fiscal 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

Ricardian equivalence
23
Fiscal policy and balance of payments

• Fiscal policy is frequently key to addressing
  balance of payments problems
• Simple mechanism
• M R D means DR DM DD DM DDG DDP
• Hence, given DM and DDP, key to raising DR is
  reducing DDG
• IMF Its Mostly Fiscal!

24
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) equals sum
  of private sector surplus of saving over
  investment (S I) and government surplus of
  taxes over public expenditure (T G)
• Equivalently, Z X I S G T means that
  external deficit equals sum of private sector
  deficit and government budget deficit

25
Fiscal policy and balance of payments

• Unsustainable fiscal policy can trigger a crisis
  if public loses confidence in governments
  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

26
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 and help restore output to full capacity,
  i.e., bring actual GDP up to potential GDP,
  especially if monetary policy is impotent

27
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

28
Global Financial Crisis and Fiscal Policy Response
2

• 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 Japans Great Recession

29
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

30
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.

31
Global Financial Crisis and Fiscal Policy Response
Multipliers again

• 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
• A rule of thumb is a multiplier (using the
  definition ?Y/?G 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.
• Smaller multipliers (about half of the above
  values) are likely for revenue and transfers
  while slightly larger multipliers might be
  expected from investment spending.
• 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.
32
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_g20_stimulus_prasad/03_g20_stimulus_prasa
d_table.pdf
33
Key Concepts

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

34
Stabilization worked, or what?
Change in Canadas per capita GDP from year to
year 1871-2003 ()
How about the U.S. next door?
Canada had no major bank failures during Great
Depression, and did not establish its Deposit
Insurance Corporation until 1967
35
Stabilization worked, or what?
Perhaps bank regulation during Great Depression
also helped stabilize GDP
Change in US per capita GDP from year to year
1871-2003 ()
36
Stabilization worked, or what?
Perhaps bank regulation during Great Depression
also helped stabilize GDP
Change in UK per capita GDP from year to year
1871-2003 ()
Not quite as clear, but standard deviation of per
capita growth fell from 3.1 1831-1945 to 1.8
1947-2003
37
Stabilization worked, or what?
Perhaps bank regulation during Great Depression
also helped stabilize GDP
Change in French per capita GDP from year to year
1821-2003 ()
38
Stabilization worked, or what?
Perhaps bank regulation during Great Depression
also helped stabilize GDP
Change in German per capita GDP from year to year
1851-2003 ()
39
Stabilization worked, or what?
Perhaps bank regulation during Great Depression
also helped stabilize GDP
Change in Swedish per capita GDP from year to
year 1821-2003 ()
Source Maddison (2003).
40
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

41
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

42
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 governments 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

43
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
44
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
45
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, 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?

46
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
• Debt accumulation can develop into a vicious
  circle
• How do we know whether a given debt strategy will
  spin out of control or not?
• To answer this, we need a little arithmetic

47
deficits and Debt
Expenditures
Revenues
Budget Deficit
Financing
Increase in debt
Higher interest payments
48
Public debt dynamics

• Recall operational budget deficit
• G T ?B ?DG ?DF ?D GN rD - T
• where D is total government credit outstanding
• Further, assume for simplicity
• T GN
• Then, we have
• ?D rD
• This gives

49
Public debt dynamics
So, now we have
Now subtract growth rate of output from both
sides
50
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
51
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.
52
Debt, interest, and growth
Deficits can be sustained as long as debt ratio
does not spin out of control i.e., at least as
long as g gt r
We have shown that
Debt ratio
r ? g
where
r g
r ? g
Time
53
Debt, interest, and growth
We have shown that
Need economic growth to keep debt ratio under
control
Debt ratio
r ? g
where
r g
r ? g
Time
54
Debt, interest, and growth
Higher interest rates can turn a sustainable debt
position into an unsustainable one
We have shown that
Debt ratio
r ? g
where
r g
r ? g
Time
55
Primary deficit GN T G T iDG Primary
balance PB T G iDG
Debt, interest, and growth

• Take another look
• Intertemporal budget constraint
• Dividing by nominal GDP ( PY), we get

If r gt g, d rises over time If r g, d remains
unchanged If r lt g, d declines
56
Debt, interest, and growth

• 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

Reducing primary deficit is key to reducing debt
ratio
pb lt 0 means that primary budget balance is in
deficit
gt 0 if pb lt 0 and g gt r
57
Fiscal reform Reducing deficits
3

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

58
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 and 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

59
Raising revenue General tips for tax design

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

60
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

61
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

62
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

63
Raising revenue number of countries with VAT
  Early 1990's Early 2000's
Americas 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

Total number of developing countries with a VAT 23 57
     
Source Keen and Simone, 2004. Source Keen and Simone, 2004.
64
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
Small Islands 10.1 8.4

Developing countries 6.5 4.2
High-income countries 3.1 1.2

Source Keen and Simone, 2004. Source Keen and Simone, 2004.  
65
Raising revenue statutory rates of personal
income tax
Source Keen and Simone, 2004.
66
Raising revenue corporate tax rates 2000 ( of
GDP)
Source Keen and Simone, 2004.
67
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

68
Reforming fiscal policyexamples

• 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

69
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

70
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

71
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

72
Wages and employment
  Average central government wage to per capita GDP Ratio of public to private sector wages General government employment as percent of total nonagricultural 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. Sources World Bank, ILO, and OECD. Data refer to 1996 - 2000 average. Sources World Bank, ILO, and OECD. Data refer to 1996 - 2000 average.
73
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

74
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

75
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

76
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

77
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 public pension programs
• Consider shifting to basic minimum benefit plus
  mandatory saving (defined contribution plan)
• U. K. (minimum benefit), Chile (more extensive
  reforms)
• Limit loan guarantees and deposit insurance
• Insurance should not provide 100 coverage

78
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

79
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 sub-federal units to evade limits

80
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

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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

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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

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The end
conclusion

• 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