Journal Issue

Formulating a Growth-Oriented Fiscal Policy

International Monetary Fund. External Relations Dept.
Published Date:
January 1990
  • ShareShare
Show Summary Details

How a fiscal reform strategy can foster more efficient resource allocation and higher growth

Fiscal policy measures play an integral role in Fund-supported adjustment programs. In short-term stabilization programs, aimed at achieving a desired outcome for the balance of payments and inflation by controlling domestic credit expansion and the exchange rate, fiscal measures are primarily directed toward staying within the ceiling on domestic credit expansion. Fund programs, however, are also designed to promote efficient resource allocation and growth. Such programs involve the integration of traditional short-term stabilization measures—essentially the correction of external and internal imbalances through aggregate demand management—with longer-term structural adjustment, aimed at stimulating the supply side of the economy.

Fiscal policy takes on greater significance in growth-oriented adjustment programs. Not only must it contribute to increasing domestic saving to finance the investment requirements associated with the growth objective, but also due account must be taken of the ways in which fiscal policy influences resource allocation and growth. Therefore, Fund programs generally contain agreements with respect to the restructuring of taxation, changing public expenditure priorities, and public enterprise reform. This article examines the nature of fiscal reforms that hold the most promise for enhancing efficiency and growth.

Fiscal policy and growth

A critical element of most Fund-supported stabilization programs is a reduction in the fiscal deficit—either through an expenditure cut or a tax increase. This is consistent with both the balance of payments and inflation targets, but could lead in the short run to a fall in the growth of output. However, if government borrowing has previously crowded out the private sector from financial markets, the reduced public sector claim on available credit and domestic saving could instead stimulate private sector investment in the long run. Moreover, if the reduction in the deficit is not achieved by cuts in public investment, an increase in productive private investment should eventually contribute to higher growth. When private investment is substituted for public investment, this will only promote higher growth if the productivity of private investment exceeds that of public investment.

While it is unclear whether a reduction in the size of government will necessarily foster growth, the structure of fiscal policy pursued by the government does influence resource allocation and growth, independently of the relative size of the public and private sectors. In most developing countries, there is scope to reform tax, expenditure, and public enterprise policies to foster growth without conceding other compelling economic and social objectives.

Tax policy. Considerable attention has focused on the relationship between the structure of taxation and its impact on resource allocation and growth. In particular, the combination of a heavy dependence on a few tax instruments—applied at high rates to a limited number of taxpayers—has resulted in severe distortions in relative prices, providing incorrect signals for investment and other economic decisions. For example, many developing countries collect a large share of total revenue from taxes on imports, but this raises protective barriers that promote inefficient import-substituting activities and discourage exports. Further, a significant part of the problem stems from inadequate administrative capabilities, which place a limit on the range of feasible tax instruments (see “IMF Advice on Fiscal Policy,” by Alan A. Tait, Finance & Development, March 1990). Administrative weaknesses also permit widespread avoidance and evasion with adverse consequences for income and wealth distribution. The challenge for tax policy, therefore, is to design tax structures that are equitable, administratively feasible, raise sufficient revenue, and minimize distortions.

The scope for tax reform varies from country to country depending on the nature of the initial tax system, administrative constraints, and the government’s social and economic priorities. Some general conclusions about the appropriate direction of tax reform in developing countries can be drawn from experience. To reduce tax rates and thereby minimize distortions, as much economic activity as possible should be brought into the tax net. Tax exemptions should be limited to only the most compelling cases. A special effort should be made to ensure that relatively fast-growing sectors are effectively taxed, although the temptation to overly tax them, and so stifle initiative in these sectors must be resisted. Such a tax structure, in combination with administrative reforms that reduce collection lags, will make the tax system responsive to increases in income, and thus minimize the need for frequent discretionary tax measures to prevent tax revenue growth falling behind that of public expenditure.

Commodity taxes should be a major revenue source. A broad-based tax on final consumption, such as a sales or value-added tax, is most desirable. This tax should have at most only a few rates, which represents a reasonable compromise between revenue needs (which argue for elaborate rate differentiation) and administrative ease (which is better served by a single rate). It should also apply equally to domestically produced and imported goods, and all inputs should be tax free. Where raw materials, intermediate goods, and capital are taxed—as in the case of a turnover tax—final prices are arbitrary and result in inefficient production decisions.

While the consumption tax should ideally apply at the retail stage, a full-fledged consumption tax requires an administrative infrastructure that one may not find in many developing countries. Administrative considerations might therefore dictate that the consumption tax be restricted to the manufacturing stage in most developing countries.

Similar considerations may also preclude the taxation of more atomistic sectors such as agriculture, small-scale business, and services; consideration could, however, be given to imposing a minimum tax on these activities. A case can be made for levying heavier taxes on certain luxury items, when ad valorem (i.e., based on the value of a transaction) rates can be used to prevent the erosion of revenue through inflation, and to discourage excess consumption of alcohol, tobacco, petroleum, and conspicuous items such as consumer durables, jewelry, and gold.

Trade taxes typically call for extensive reform in developing countries (see “The Fiscal Implication of Reducing Trade Taxes,” by Adrienne Cheasty, Finance & Development, March 1990). Import taxes should be set only with a view to establishing a desirable level and pattern of effective protection. To prevent large revenue losses resulting from import taxes in many cases, the appropriate measure is an increase in general consumption taxes. Many countries levy export taxes, especially on major agricultural products. Since these provide a disincentive to exports—and given the strong link between exports and growth—they should, in general, be eliminated. An exception could arise where it is administratively and politically difficult to tax agricultural incomes and land taxation is impractical. In such circumstances, an export tax may be a reasonable proxy for a tax on farmers’ incomes. Where administratively feasible, such a tax should be accompanied by a presumptive tax on the rest of the agricultural sector to preserve equity and the incentive to export.

Personal income taxes present something of a problem in developing countries. They tend to be more difficult to administer than consumption taxes, while their base comprises the wage bills of the public sector and only of large private sector companies, and is therefore limited. The resulting high tax rates are usually associated with disincentives to work and save, as well as evasion and avoidance. Hence, the equity objectives of income taxes are not well served. A more efficient and equitable structure would feature a large exemption with low, and at most, mildly progressive, marginal tax rates. Tax brackets should be indexed to ensure that taxpayers are not exposed to higher tax rates simply as a result of inflation. While incentives and compliance should improve, so that revenue targets are not compromised, the combination of the large exemption and a fairly flat rate structure would still result in significant redistribution of income. Indeed, many low income workers need not pay tax at all. As mentioned above, the overall effectiveness of such reforms, however, depends critically on establishing the administrative capability to ensure broad coverage of the income tax, accurate reporting of income to the revenue authorities, and efficient tax collection.

Since companies are indistinguishable from their owners, an effective personal income tax—where all corporate profit is allocated to shareholders—would appear to eliminate the need for a separate company tax. Such taxes are nevertheless commonplace. One explanation for this relates to the administrative problems involved in effectively taxing the profit of international companies under a personal income tax. Another justification for company taxation—more applicable in developing countries than elsewhere—is that it is easier to levy tax at the corporate level. A company tax, however, tends to fall not only on the returns to investment but also on investment itself. This is because existing systems of depreciation and other investment allowances tend to result in only partial relief of investment from tax. Taxing investment, even in part, tends to reduce the amount undertaken; further, the method of taxation certainly distorts investment decisions. In principle, full expensing of new investment eliminates the tax disincentive to investment. But given that it also reduces tax revenue significantly compared to existing arrangements of phased depreciation allowances, a compromise would be to raise initial depreciation allowances, apply them uniformly across investments and sectors, and eliminate all other allowances.

Expenditure policy. Public expenditure can support the growth process through a number of channels. The public sector can undertake large-scale investments, such as infrastructure projects, that are beyond the scope of private investors; it can supply social goods, such as education and health, that raise the stock of human capital and its productivity; and it can itself provide or encourage private provision of a wide range of directly productive goods and services. Further, the resulting political and social stability brought about by government expenditures, can provide an environment conducive to growth. However, the body of knowledge on the desirable direction for expenditure reform has not produced a cohesive package of structural measures similar to that described in the case of tax policy. But, again, experience suggests the desirability of certain reforms.

… the growth objective should play a central role in determining how fiscal adjustment is achieved.

A good public investment program can encourage growth. Efforts should be made to ensure that the public investment program comprises high quality projects that are justifiable on economic grounds, taking due account of social objectives. While there has been a temptation to believe that the distinction between capital and current expenditure bears some relation to growth prospects, this is clearly misleading. There are numerous examples of capital projects that have no merit from the point of view of growth. At the same time, appropriate current expenditure programs are an essential complement to both public investment and private sector activity. Thus, public investment expenditure should also be supported by sufficient funds for the appropriate operation and maintenance of capital projects, which increase the productivity and longevity of the existing capital stock. In this connection, the World Bank has carried out extensive analyses of public investment and expenditure programs as part of its program and project lending operations. The focus of these analyses is a review of the public investment program, associated recurrent expenditures, related institutional processes, and the macro-economic framework for the sustainability of the program in the medium term.

For the other categories of current expenditure, wage levels should be adequate to guarantee that the public sector can retain the quality of manpower it needs, and thereby provide effective public administration. Particular attention should be paid to maintaining performance incentives through appropriate pay differentials. In many cases, a restructuring of employment—involving both redeployment and redundancies—will be an essential complement to a reformed wage policy. Materials and supplies must also be sufficient to ensure that public employees can function efficiently.

It must, however, be recognized that the scope for discretionary expenditure adjustments is often limited, especially in the short term. For example, some elements of expenditure, such as interest payments, cannot be changed, while other categories, such as military spending, tend to be fairly resilient to adjustment. It is, therefore, essential that every effort is made to ensure that, where the flexibility exists, the objectives of an expenditure program are both justifiable and met in an efficient manner. In this connection, spending on subsidies warrants special attention. Although in many cases subsidies can be easily justified, there are numerous examples of expensive subsidies that can either meet their objectives at substantially lower cost—for example, through more careful targeting—or, in the extreme cases, have no compelling economic and social justification.

Public enterprise policy. The operations of nonfinancial public enterprises have been a major source of weakness in the public finances of many countries. A number of factors have contributed to their poor performance. These include: complex bureaucratic relations between the government and public enterprises; the need to pursue a wide range of social and other non-economic objectives; the protected monopoly status of many enterprises; administrative control of public enterprise prices; powerful trade unions; and the willingness of the government to cover public enterprise losses. In this environment, public enterprises have emerged as typically inefficient producers relying heavily on budget subsidies. They tend to be overmanned, with wage levels significantly out of line with productivity, the quality of management is often poor; investment decisions are not made on economic criteria; and capacity utilization is low and usually subsidized, while input and output prices are out of line with international prices.

While the problems associated with public enterprises are widely recognized, effective solutions have been slow to emerge. Moreover, in this area the lag between implementation and response is particularly long. However, the identification of the sources of poor public enterprise performance helps define the principal elements of a reform strategy. In particular, emphasis should be placed on freeing public enterprise management from political and ministerial interference, giving them greater autonomy over pricing and investment decisions, and letting them pursue clearly specified objectives. In many cases, major efficiency gains can be expected from exposing enterprises to competition and, where it serves the promotion of competition, privatizing enterprises (see “Is Privatization the Answer?” by Richard Hemming and Ali Mansoor, Finance & Development, September 1988). Even in those cases where public monopoly is inevitable—for example, in markets where average costs are continuously decreasing—there are often particular activities that can be contracted out to the private sector. It is of critical importance that the government provide financial support for public enterprises only on a selective basis, particularly for enterprises that have clear social objectives. Enterprises that are expected to operate commercially, but may not be able to survive in a competitive environment, should be privatized, and if that is not possible, liquidated.


A full-fledged fiscal reform package of the type described above would clearly be an ambitious undertaking. In many developing countries, some reforms have already been set in place; in others, however, there are constraints that limit the changes that can realistically be implemented. Reform has to be designed on a case-by-case basis. But even a relatively modest package could represent a major dislocation and create much political difficulty. Stabilization objectives may also be frustrated, especially in the short term. This, however, should not be taken to imply that priority should no longer be given to reducing the fiscal deficit. Sound demand management policy remains essential both to the creation of investor confidence and the maintenance of credibility on international capital markets ensuring external resource availability. The rationale for the fiscal reforms described in this article is derived from the view that the growth objective should play a central role in determining how fiscal adjustment is achieved.

Other Resources Citing This Publication