The average fiscal deficit of advanced economies is set to narrow by 1½ percent of GDP in 2013 (in both headline and cyclically adjusted terms), the fastest pace since consolidation efforts started in 2011. This average, however, reflects different trends across countries: some economies are stepping up adjustment efforts, while others are tapering them off, and still others are adopting a looser stance to support growth. Nevertheless, relative to previous projections, fiscal deficits are somewhat larger in most countries, reflecting a weaker economic environment (Figure 1, Table 1). Although 2014 budgets are in most cases still to be fleshed out, fiscal tightening is expected to moderate significantly next year as a large part of the consolidation has already taken place or is close to completion. On average, close to two-thirds of the adjustment required to reach medium-term targets has been achieved in the 10 most highly indebted countries, with the notable exception of Japan.
Weakening growth and policy uncertainties cast a shadow over the fiscal outlook, even as budget deficits narrow and recent announcements by monetary authorities provide some respite on the financial front. Countries with stronger fiscal positions and lower public debt, including several emerging market economies, can afford to pause fiscal consolidation efforts, but in others adjustment must proceed at a pace that reflects medium-term adjustment needs, the state of the economy, and financing constraints. Where financing permits, flexibility should be allowed for automatic stabilizers to play in response to moderate growth shortfalls. Should growth fall well short of current expectations, countries with space should smooth their adjustment paths over 2013 and beyond. The United States and Japan must promptly define and enact clear and credible plans to return to fiscal sustainability over the medium term and buttress investor confidence.
Almost all advanced economies have implemented significant fiscal adjustment since 2010. Nevertheless, their current fiscal positions differ significantly, primarily reflecting uneven starting conditions and differences in the impact of the crisis on their fiscal accounts, rather than variations in the extent of postcrisis adjustment.
After a brief respite following the announcement of new initiatives in mid-July, market concerns about fiscal sustainability in the euro area have reignited. Worsening market sentiment has spread beyond the smaller economies to which it had more recently been confined and poses risks that, if realized, could end up in vicious debt spirals.
Consolidation efforts are yielding fruit, at least for deficits. In 2013, cyclically adjusted deficits are expected to fall below their precrisis levels in about half of the countries included in the Fiscal Monitor database.2 The evolution of debt ratios is more varied: they have declined in most emerging market economies, but not in most of the advanced economies, reflecting in many cases higher interest rate–growth differentials in the latter group. Consolidation packages have typically attempted to focus on measures that are supportive of potential growth, but countries with large adjustment requirements have had to use a broader brush, in many cases cutting public investment and raising income taxes. Institutional reforms have also been introduced to strengthen governance and credibility, including—but not only—in the euro area.
Taxation is rarely far from the news, but it has seldom been so central to public debate, in so many countries, as now. This section takes stock of developments on the revenue side since the onset of the global economic and financial crisis and explores whether and how tax reform can help strengthen public finances. It asks: Can countries tax more? Can they tax better? And what can they do to increase the legitimacy and sustainability of their tax systems?
Notwithstanding the progress mentioned in the preceding section, large financing requirements remain a source of near-term fiscal vulnerability in several advanced economies, while prospective increases in age-related spending loom large over the long-term horizon for many of them. Moreover, fiscal risks around the baseline projections are on the rise across country groups, given the uncertain growth outlook and large contingent liabilities, particularly from the financial sector.19 If history is a lesson, the path to restoring fiscal sustainability will be long and arduous for most advanced economies. Maintaining adjustment efforts over the long term will require packages that mesh flexibility and credibility (through the use of structural or cyclically adjusted targets), limit adverse social effects, and boost employment and labor supply through appropriate tax and other spending policies, backed by strong fiscal institutions.
Borrowing costs remain extremely low for the United States and Japan, even though their fiscal indicators are generally no stronger than those of several countries currently under market pressure. Interest rates for these two economies have remained low throughout the crisis and its aftermath and have declined further during 2011, even after the downgrading of U.S. debt in early August by one rating agency (Figure 1). These low rates—which stem from weaknesses in the expected recovery, expectations of low short-term interest rates, and flight to safety in unsettled global financial markets—are reflected in low borrowing costs and, ultimately, provide sizable benefits to fiscal policy sustainability. The relatively benign treatment by market participants of sovereign bonds issued by Japan and the United States, however, may not fully reflect fiscal fundamentals: current general government debt and deficits, and projected increases in debt over the next five years, are at least as high for the United States and Japan as they are for several euro area economies under market pressure or the euro area in general (Figure 4). In addition, projected long-term increases in pension and health care spending in the United States are larger than in many euro area economies. Japan and the United States face the largest gross financing requirements among all advanced economies this year and are projected to do so in 2012 and 2013 as well, reflecting their large deficits and debt stocks as well as their still relatively short debt maturity profiles (Table 3), notwithstanding some success in lengthening maturities in recent years (Figure 5).