Front Matter

Editor(s):
Vito Tanzi
Published Date:
June 1990
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    © International Monetary Fund, 1990

    Library of Congress Cataloging-in-Publiction Data

    Fiscal policy in open developing economies/edited by Vito Tanzi.

    p. cm.

    Based on papers presented at the 44th Congress of the International Institute of Public Finance, held in Istanbul, August 22-25, 1988.

    Includes bibliographical references.

    ISBN 1-557-75118-8.

    1. Finance, Public—Developing countries—Congresses. 2. Fiscal policy—Developing countries—Congresses. 3. International economic relations—Congresses. 4. Developing countries—Foreign economic relations—Congresses. 5. Economic stabilization—Developing countries—Congresses. 6 Developing countries—Commercial policy—Congresses. I. Tanzi, Vito. II. International Institute of Public Finance. Congress (44th : 1988 : Istanbul, Turkey).

    HJ1620.F56 1990

    336′.0917′4—dc20

    Price: $15.00

    90-5136

    CIP

    Foreword

    If there is one truth that we have learned in our daily work at the International Monetary Fund, it is that countries, and particularly developing countries, are not isolated islands, but rather are open to influences, positive or negative, from other countries. Another truth is that fiscal policy plays a dominant role in magnifying or reducing these influences. An open economy that pursues good policies is likely to derive great benefits from its openness. One that pursues poor policies can be expected to blame its openness for its problems.

    This book, written by economists from many countries and from many institutions, including the IMF, deals with the interconnection between public finance and economic performance. It addresses analytical issues and concrete experiences of countries with which the IMF has had close and often continuous relations. Almost all the papers in this book were written by economists involved with policymaking. Since not all the authors are Fund staff members, the experience reflected in this book transcends that of the Fund. As a consequence, some of the opinions expressed may not necessarily be shared by this institution.

    In addition to its direct, operational work with countries, over the years the Fund has contributed to promoting good policies through its publications. Through these it has brought to the attention of the public the lessons that it has learned from its operational work. I consider this a form of generalized technical assistance since it is broadly available to everyone and at very low cost.

    I strongly hope that this publication will in some way improve policymaking in member countries. If it contributes to a better understanding of the issues discussed, it cannot fail to do so.

    Michel Camdessus

    Managing Director

    International Monetary Fund

    Introduction

    Vito Tanzi

    This book contains 13 chapters dealing broadly with public finance and macroeconomic policy in open, developing economies. It is based on unpublished studies written for, and presented at, the 44th Congress of the International Institute of Public Finance held in Istanbul, 22–25 August, 1988. The authors are all economists with considerable policy experience. For the most part they are, or have been, associated with international institutions, such as the Arab Monetary Fund, GATT, the Gulf Cooperation Council, the International Monetary Fund, the Organization of American States, the Organization for Economic Cooperation and Development, the World Bank, and the United Nations.

    The book is broadly divided into two parts. The first part, which contains seven chapters, deals with general aspects. The second part, which contains six chapters, presents case studies of four interesting countries (Chile, Korea, Mexico, and Turkey), and two areas, the Arab world and commodity-exporting developing countries. Many economists from industrial countries do not fully appreciate the extent to which the public finances of developing countries are influenced by, and may in turn influence, the external sector of these countries. Most chapters outline the channels through which these influences make themselves felt. Many topics now attracting much attention on the part of economists and policymakers are discussed in some of the chapters as, for example, the relationships between devaluation and fiscal balances, between trade liberalization and fiscal balances, the connection between export instability and revenue instability, the possibility of pursuing policies aimed at insulating the economy and the fiscal accounts from the fluctuations in export earnings, and so forth.

    The first chapter, by Johannes Linn and Deborah Wetzel, is a broad survey written from the perspective and the experience of economists associated with the World Bank, who can rely on a wealth of information from published and unpublished World Bank studies. The authors discuss the linkages between fiscal policies and trade policies and their influence in the development performance of developing countries. They emphasize that a stable macroeconomic framework is fundamental in the pursuit of good economic policy. Such a framework requires an appropriate exchange rate, sound fiscal management, and trade liberalization. One cannot talk about efficient use of public finance tools when the fiscal accounts are unbalanced to an extent that negatively affects the macroeconomic activity. Unbalanced fiscal accounts need to be corrected, and this correction must come through a variety of channels. However, the correction at the macroeconomic level cannot ignore the need to use efficient tools. The authors discuss some of the costs associated with price distortions and the choice of poor taxes and a poor pattern of government spending.

    The second chapter, by Theo Hitiris, is an empirical investigation of the relationship between tax structure and economic development using various sophisticated statistical techniques applied to cross-sectional data for 105 countries. He investigates the changes that occur in the tax structure of countries when countries develop. While this is not the first study of its kind, the Hitiris study is interesting both because of the methodology used and because of the large sample to which the methodology is applied. Most of the countries for which the data were available have been included in this analysis. He confirms the results of earlier studies which show that there is a clear connection between tax structure and economic development. Perhaps the most specific result of this analysis is that the growth of per capita income will reduce the importance of foreign trade taxes but will increase the importance of income taxes.

    The third chapter, by Juan Carlos Gómez-Sabaini, discusses the many reasons that have led countries to use export taxes. While this discussion is of general relevance, it is of particular significance to Argentina, a country which, in recent years, has relied heavily on export taxes. Export taxes have often been criticized by economists because of their negative impact on the production and on the export of traded goods. An export tax is in fact analytically equivalent to a production tax accompanied by a subsidy to the domestic production of the commodity taxed. In other words, an export tax discourages production at the same time that it encourages the domestic consumption of the product. Gómez-Sabaini points out that, in spite of this negative effect, export taxes continue to be relied upon by many countries. He explains that there are many objectives, besides revenue generation, which the government attempts to achieve through the use of these taxes. However, it is doubtful that the benefits associated with the use of these taxes can compensate for the costs they impose on the economy. This chapter concludes with a brief description of export taxation in Argentina.

    The relationship between fiscal policy and the exchange rate is discussed in various chapters and from different angles. The first of these chapters, by Jesús Seade, addresses the issue of whether an adjustment in exchange rates affects tax revenue. Does a devaluation, for example, necessarily increase tax revenues as the editor of this book has argued in a recent article? Using a general equilibrium framework, Seade concludes that this result depends very much on the structure of taxes, or alternatively on how in reality different tax bases are effectively taxed. He argues that a change in exchange rate may simply shift the value-added generated by the economy from one part of the economy to another without necessarily changing the total taxable capacity of the country. However, he agrees with Tanzi that in the real life conditions prevailing in the majority of developing countries, a devaluation is likely to raise government revenue since it shifts taxable value-added toward the foreign trade sector where tax bases are more easily taxable. Seade's analysis is useful because it provides a general framework for assessing a particular problem. It is also useful because it shows that at times a partial analysis may give answers which are not necessarily correct.

    The chapter by Mario Blejer and Adrienne Cheasty also deals with a topic that is attracting a lot of attention and on which there is much disagreement among economists, namely the fiscal impact of trade liberalization. Trade liberalization is becoming progressively more popular among policymakers, and several countries have already pursued, or are contemplating pursuing, trade liberalization policies. However, some economists have cautioned against this policy on grounds that the fiscal impact would be negative since these policies would result in losses in tax revenue and in higher expenditure to compensate those who lose jobs or to provide higher subsidies to some enterprises. Blejer and Cheasty analyze at some length these issues and conclude that even if the liberalization process produces a clear improvement in the fiscal balance in the long run, short-run effects, as well as the process of adjustment to more open trade, may be costly for the government. In particular circumstances trade liberalization may lead to a worsening of the fiscal accounts and to other problems. They conclude that, unless these temporary costs are anticipated, they could force governments to reverse the liberalization. The long-run gains to the budget from the liberalization-induced expansion of income will be realized only if the tax and transfer systems are broad, neutral, and efficiently administered.

    Reisen's paper deals with the impact of real changes in the exchange rate not on tax revenue but on the public budget, especially in the presence of large external debts. A large foreign debt implies that the servicing cost of the debt expressed in domestic currency would increase when the exchange rate is depreciated. This increase in expenditure many overwhelm the positive impact of devaluation on tax revenue. On the basis of some countries' experiences, Reisen analyzes the specific conditions under which, given the foreign debt, devaluation will improve the fiscal accounts.

    Fuat Andic, Suphan Andic, and Irma Tirado de Alonso address the problem of revenue instability that affects many developing countries that export commodities subject to large fluctuations in prices. (This problem is also discussed in the chapters by Chu and by El-Kuwaiz.) Depending on the type of taxation in use, tax revenue can fluctuate wildly and can also influence the behavior of expenditure. Are there schemes that can stabilize public sector revenue over time? And can governments resist the temptation to spend additional revenues in boom years? The authors discuss various proposals aimed at insulating the budget (and the economy) from these fluctuations. On the basis of an empirical analysis of various experiences, they conclude that policies to stabilize tax revenue can at best have limited scope, since they can be feasible only if export prices were to fluctuate around a rising trend, and that the major obstacle to domestic stabilization comes from political constraints.

    Ke-young Chu's paper addresses issues similar to those discussed by Andic, Andic, and Tirado de Alonso. It also deals with the broad characteristics of public finances in commodity-exporting countries.

    These finances are very unstable as a reflection of unstable world commodity prices and the narrowness of tax bases. The author shows that under the conditions prevailing in many developing countries unstable revenue poses great difficulties for the pursuit of fiscal policy. To maintain a stable deficit, expenditure will have to fluctuate wildly imposing serious efficiency and social costs on the country. Maintaining a stable expenditure, the deficit will have to fluctuate but this raises questions as to the financeability of the deficit.

    Abdullah El-Kuwaiz's paper follows up on the issue of revenue instability by dealing with the experience of Arab countries with oil exports. The public finances of these countries are very dependent on oil revenue and the price of oil has fluctuated wildly over the past two decades. He focuses on the fall in oil revenues in the 1980s and the impact of this fall on the development plans of Arab countries. One beneficial effect of this fall has been to induce a careful reappraisal of development plans. By forcing these countries to scrutinize public spending more closely, it has increased the productivity of public spending and the quality of the administrative mechanisms that control that spending. These countries are now much better prepared to use wisely the revenues that they will continue receiving from oil exports. The drop in oil revenue has also induced these countries to look for alternative revenue sources realizing that over the longer run they cannot keep relying mainly on oil as the major generator of public sector revenue. Between 1975 and the most recent years, oil revenue of Arab oil-exporting countries as a percent of total government revenue has fallen from 95 percent to just over 50 percent.

    Vittorio Corbo, Guillermo Ortiz, and George Kopits and David Robinson deal respectively with Chile, Mexico, and Turkey, countries that have attracted a lot of attention in recent years. These authors try to assess the relationship between public finance and the economic performance of these countries.

    Corbo's chapter on Chile provides a careful survey of 15 years of Chile's experience and reaches some rather strong conclusions. The reduction of the fiscal deficit and the scaling down of the size of the public sector required strong actions on both the revenue and the expenditure side. Both the tax system and the system of public expenditure were dramatically and successfully restructured. The distortionary effects of taxes and revenues were sharply reduced and the productivity of public expenditure was greatly increased. Corbo concludes that the elimination of the large public sector deficit was a necessary and important condition but it was not a sufficient condition to contain inflation. Income policies are also often necessary especially when an element of inertial inflation is present. Once the macroeconomic situation is under control and the major structural impediments have been removed, growth can resume even in a country as indebted as Chile.

    The chapter by Guillermo Ortiz, dealing with Mexico, focuses on the issues of whether the adjustment in the external accounts of Mexico in recent years was also accompanied by an internal adjustment since, at least for a while, a high rate of inflation and a large fiscal deficit accompanied the external adjustment. By using alternative concepts of the fiscal deficit—such as the operational deficit and the primary balance—Ortiz argues that in fact there was a major internal adjustment as well. However, he argues that the servicing of the external debt created substantial inflationary pressures. Furthermore, by sharply reducing public investment, the servicing of the debt may have reduced the country's ability to grow. The contrast between Corbo's and Ortiz's analysis provides an interesting example of how the experience of two countries has varied and how two able economists have interpreted that experience.

    George Kopits and David Robinson discuss the Turkish experience in the 1980s. In this decade Turkey emerged from a severe balance of payments crisis and five decades of virtual economic isolation. The external imbalance was substantially reduced and economic growth resumed. Fiscal policy played a large role in this process. After providing an overview of the macroeconomic development, the authors build a model to simulate alternative combinations of fiscal and exchange rate policies during 1984–87. One conclusion that they reach is that protection of the balance of payments through real depreciation of the exchange rate, while not tackling the problem of the fiscal imbalance, is not a viable option over the medium term. These conclusions have clear relevance especially for some Latin American countries.

    The last chapter, by Taewon Kwack, deals with the Republic of Korea, a country that has received a lot of praise for its successful economic policy. Over the past 25 years, the Korean economy has been transformed from a poor agrarian economy to a dynamic industrial economy which can compete with the most advanced countries in many sectors requiring sophisticated technology. Korea has been successful in overcoming the problem of foreign debt, inflation, and what seemed to be chronic deficits in foreign trade. In the early 1980s, it had problems similar to those of highly indebted countries. By the end of the decade, its foreign debt was being reduced at a remarkable pace. Using the concept of cost of capital, Kwack tries to assess the role of fiscal incentives in this process and especially in export promotion. Many export incentives are given through the tax system, others through financial policies. Kwack shows that the export sector has been enjoying very large benefits from these export promotion schemes. However, he concludes that financial incentives played a large role while tax incentives played only a minor role.

    I hope that the readers will find this book useful and that, in some small way, it will improve economic policymaking in many countries. As Chairman of the Scientific Committee of the 44th Congress of the International Institute of Public Finance I would like to take this occasion to thank the other members of that Committee—Messrs. F. Batirel, Hans van der Kar, Gerold Krause-Junk, Peter Med-gyessy, Halil Nadaroglu, Remy Prud'homme, and Hirofumi Shibata—for the assistance they provided to me. I also wish to thank Marmara University for hosting the conference, and Professor Victor Halberstadt, then President of the IIPF, for his general support and encouragement. Finally, a special thanks must go to David Driscoll for dealing with the many important tasks that go with the preparation of a book.

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