Governments facing high debt levels and seeking to undertake fiscal consolidation are often confronted with a number of interrelated questions. What promotes a successful fiscal consolidation? How large should the adjustment be and how fast? Should one adjust now or later, and what are the consequences of postponing adjustment? Should one cut expenditures, raise revenues or do both? Which components of expenditures or revenues should one adjust, and does the composition of adjustment really matter? Would the adjustment be self-defeating? Is there a political price for fiscal adjustment?
Following two approaches, this chapter attempts to answer many of these questions that policymakers may have in their quest for fiscal consolidation. First, the chapter undertakes a comprehensive survey of a large body of mostly empirical literature on fiscal consolidation, covering industrial, emerging market, and developing economies. Second, it explores specific country experiences with fiscal consolidation dating back to the 1990s, examining 25 case studies, consisting of 14 advanced, 8 emerging market, and 3 developing economies, including Barbados and Jamaica. In doing this, it focuses on the prevailing economic and political conditions preceding fiscal consolidation, the various measures adopted, the composition of adjustments, and the achievements.1 The ultimate goal is to draw useful lessons on the determinants of a successful fiscal consolidation.
To motivate the discussions, the chapter first lays out the theoretical background to the debate on fiscal consolidation before discussing the evidence from the empirical literature.2 It next examines country experiences with fiscal consolidation.3 It ends with a summary of the main lessons from the literature and country experiences and concluding remarks.
The Fiscal Consolidation Debate: Theoretical Background
The debate over fiscal consolidation is a long-standing one and will continue to attract attention in the future. Despite the often-cited long-term benefits of fiscal adjustment, there continues to be concern about the short-term costs. More so, fiscal consolidation appears unavoidable in the current environment of low growth, high debt, and deteriorating fiscal performance. In any case, as de Rato (2004, p. 1) points out, “the reality is that countries that decide to postpone fiscal reform and adjustment for fear of the political and economic consequences usually end up paying a much higher price when economic necessity forces them to act.”
The debate stems from the standard Keynesian proposition that fiscal adjustment has a contractionary effect on economic activity in the short run. Lower government expenditures and increases in taxation both reduce aggregate demand and therefore output via the multiplier. This conventional wisdom is questioned by Giavazzi and Pagano (1990), who point to two episodes in Denmark and Ireland in the 1980s in which a sharp fiscal consolidation was associated with a surprisingly large expansion in private domestic demand. These were the so-called expansionary fiscal contractions. Following subsequent studies, there appears to be a consensus that fiscal consolidation is not always self-defeating, and several theoretical justifications of its non-Keynesian effects have been offered in the literature.
The question then is what makes fiscal contractions expansionary? A prominent view—one firmly rooted in rational expectation theory4—suggests that there is a strong private sector response to fiscal consolidation on the demand side, operating through wealth effects on consumption and credibility effects on interest rates. First, the wealth effect on consumption implies that fiscal restraint may give rise to expectations about future tax cuts and hence a higher permanent income for households, which in turn would stimulate private consumption and investment and therefore output.
A second channel of wealth effects identified in the literature arises from the decline in interest rates that may accompany fiscal adjustment. In the view of Alesina and Perotti (1997), fiscal consolidation, particularly a strong one in a high-debt country, may have far-reaching credibility effects on interest rates by lowering risk premiums, which can be of two types: inflation risk premiums and default (or consolidation) risk premiums. To these authors, the default risk premium is non-trivial for a high-debt country. They argue that decisive steps to reduce fiscal deficits and public debt are capable of bolstering market confidence through a fall in the sovereign risk premium, thereby crowding in private investment and consumption, notably investments and consumption that are sensitive to interest rates.5
Further, as highlighted by Alesina, Prati, and Tabellini (1989) citing the case of Italy, countries facing high levels of debt with short term maturity may face a self-fulfilling confidence crisis. That is, if the public expects that in the future the government will be unable to roll over the maturing debt, the public may refuse to buy debt today and choose to hold foreign assets instead.
The confidence effect is visible in the favorable responses to fiscal consolidation of the stock market and real estate prices. It is especially pronounced if solvency is an issue or policy credibility is low (de Rato, 2004), in which case fiscal consolidation must be understood as part of a credible plan designed to permanently reduce the government deficit and therefore future tax liabilities (Giavazzi and Pagano, 1995; and Giavazzi, Jappelli, and Pagano, 2000). Put simply, the government must be able to signal a break from the past to attract financial markets and the public. However, according to Hjelm (2002a), a strong private sector response to fiscal consolidation may be due to country-specific factors. Thus, the expectation view may not be true in general.
While the wealth effects on private consumption emanating from permanent reductions in government expenditure are expansionary, there is a concern that the same wealth effects could affect labor supply through substitution effects.6 As Alesina and Perotti (1997) note, if both consumption and leisure are normal goods, then a wealthier consumer would want more of both and therefore work less. Thus, an alternative view—the supply side or labor market channel—underscores the importance of adjustment composition, suggesting that income tax increases and wage and transfer cuts have opposite effects on private sector labor costs and therefore on competitiveness and growth (Ardagna, 2004; and Alesina and Perotti, 1995). Alesina and Perotti (1997) make the case that the labor cost channel may be more empirically relevant for consumption than the wealth effects and credibility channels.7 Under different exchange rate regimes, Lane and Perotti (2003) analyze the impact of fiscal policy through the labor cost and exchange rate channels, and conclude that wages and prices need to be partially flexible for both channels to be effective. When wages and prices are fully flexible, the exchange rate channel breaks down. On the other hand, if wages and prices are fully rigid, there are no short-term adjustment costs.
Nonetheless, the short-term adjustment costs and distributional effects cannot be ignored. Indeed, Coenen, Mohr, and Straub (2008) develop a theoretical model to demonstrate that irrespective of the strategy adopted, adjustment costs are evident. The distributional effects can be pronounced, depending on the adjustment strategy and, in particular, on the extent to which households differ with regard to their ability to participate in asset markets and their dependence on fiscal transfers. Similarly, analyzing fiscal consolidation in a small open economy, Almeida and others (2011) find short-term costs, notably on output, consumption, and welfare.
Over the medium to long term, fiscal consolidation can be good for growth, and hence may not trigger an economic slowdown. Coenen, Mohr, and Straub (2008) identify positive long-term impacts on macroeconomic aggregates, such as output and consumption, when the resulting improvement in the budgetary position is used to lower distortionary taxes. Their conclusion is supported by Almeida and others (2011), who note that the consolidation gains are boosted if the strategy also involves a tax reform that shifts the tax burden away from labor income and toward final goods consumption. The creation of fiscal space after debt reduction in the long term would permit cuts in corporate income taxes (Kumar, Leigh, and Plekhanov, 2007).
Fiscal Consolidation: A Survey of Empirical Evidence
Turning now to the empirical literature, evidence broadly supports the view that fiscal consolidation can be expansionary under certain circumstances (Alesina and Perroti, 1995; Alesina, 2010). Alesina, Favero, and Giavazzi (2012), for example, examine whether fiscal consolidation causes large output losses. They demonstrate that adjustments based on spending cuts are much less costly in terms of output losses than tax-based adjustments. An analysis of the short- and long-term effects of fiscal adjustment in the OECD economies by Kumar, Leigh, and Plekhanov (2007) indicates that short-term negative effects are moderate and are not generally widespread. The contractionary effects, they find, are lower when consolidation involves increases in consumption taxes, and are largest when it involves cuts in productive expenditure.
Probit regression estimates by Giudice, Turrini, and in’t Veld (2007) indicate that episodes in the European Union that turned out to be expansionary were more likely to start in periods with output below potential. According to Alesina and Perotti (1995) and Alesina and others (1998), fiscal adjustments crowded in business investment and improved competitiveness and therefore growth. Guajardo, Leigh, and Pescatori (2011) examine historical records to identify fiscal policy changes intended specifically to reduce budget deficits. Using a somewhat different measure than the conventional definitions of fiscal stance, they provide contrasting evidence that fiscal consolidation has short-term contractionary effects on private domestic demand and output. Estimates based on conventional measures of fiscal stance support the expansionary view, but the authors claim that the effects may be overstated in the literature.
What Really Triggers Fiscal Consolidation?
Evidence suggests that fiscal consolidation occurs when government finances are in bad enough shape to threaten fiscal sustainability (Ahrend, Catte, and Price, 2006; Price, 2010; Kumar, Leigh, and Plekhanov, 2007). In their studies of large adjustments across a wide range of countries, including developing economies, Tsibouris and others (2006) show that many large fiscal adjustments have been initiated against the backdrop of difficult macroeconomic conditions, including sluggish growth, higher debt, and high inflation. In extreme cases, fiscal consolidation is undertaken when the level of inflation, the exchange rate, and unemployment suggest a crisis situation (Ahrend, Catte, and Price, 2006).
Guichard and others (2007) analyze the OECD experience dating back to the late 1970s and provide evidence on the macroeconomic conditions and policy set-ups that have aided and sustained fiscal consolidation. Their main findings are that large initial deficits and high interest rates were important in initiating fiscal consolidation and also in boosting the size and duration of fiscal adjustments. The presence of a systemic financial crisis, which calls for banking sector repair, signals the need for consolidation (Barrios, Langedijk, and Pench, 2010). Alesina, Ardagna, and Trebbi (2006), and Drazen and Grilli (1993) argue that sometimes crisis situations are desirable because they force the government to undertake necessary reforms needed to improve economic welfare.
What Promotes a Successful Fiscal Consolidation?
Findings concerning what promotes a successful fiscal consolidation—and therefore debt reduction—point to a range of factors. In terms of positive growth effects, evidence suggests that fiscal consolidation is far more likely to succeed when countries approach a critical level of macroeconomic instability, whether arising from a chronic tendency to increase budgetary expenditures, debt problems, or balance of payment difficulties (de Rato, 2004). Ardagna (2004) suggests that while higher GDP growth matters, it does not drive the success of consolidation. Alesina (2010) argues that high inflation (or the hyper type) and sustainable growth may not occur often enough to reduce debt. In a study of 25 emerging market economies, Gupta and others (2003) find that sustained fiscal adjustments are affected by the legacy of past fiscal failures, the size of the deficit, the initial debt stock, exchange rate movement, inflation, and the unemployment rate. Perotti (1999) provides considerable support for the finding that when debts are initially at critical levels, fiscal consolidation is more likely to succeed, whereas Heylen and Everaert (2000) disagree, arguing that the success of consolidation is not clearly affected by initial debt conditions.
Do the Composition and Size of Fiscal Adjustment Matter?
Regarding the composition and size of fiscal adjustments, the general consensus is that for a fiscal adjustment to be credible it must be of considerable size. Numerous studies suggest that there are size and composition effects of successful fiscal consolidations, as they signal commitment and raise the probability of success. For example, examining a panel of OECD countries, Ardagna (2004) finds that the larger the initial adjustment, measured by the change in primary fiscal balance, the larger is the likelihood of success.
While other studies indicate that the composition is fundamental for success (Alesina and Perotti, 1995; Alesina and Ardagna, 2009; Alesina and others, 1998; Lane and Perotti, 2003), Ardagna (2004) argues that success depends more on the size and less so on the composition. Controlling for exchange rate depreciation and changes in money supply, Hjelm (2002b, 2004) concludes that the composition effect disappears. It is believed that the effects of composition on growth works mostly through the labor market channel rather than the expectations channel. Bi, Leeper, and Leith (2012) introduce uncertainty over the timing and composition of adjustment in the context of a nonlinear DSGE specification; they find that, among other things, the nature of fiscal consolidation, its duration, and the expectations of its likelihood of occurring and composition are all significant.
Which Is More Effective, Expenditure Cuts or Revenue Increases?
There is strong evidence that expenditure reductions outweigh revenue increases on successful fiscal consolidation. As pointed out by Price (2010), it is probably because expenditure measures reflect greater commitment, make substantial consolidation more feasible, and can lead to efficiency gains. Spending cuts are more important than tax increases in boosting confidence, and are more effective when they involve permanent reduction in outlays (de Rato, 2004). But it is also acknowledged that such cuts will be difficult in countries with urgent social needs and infrastructure deficiencies. In such cases, better expenditure targeting becomes crucial. Furthermore, according to Alesina (2010), lowering spending is also much more effective than increasing taxes in stabilizing the debt and avoiding economic downturns. Successful consolidations are based on expenditure reductions as opposed to major tax increases, or in conjunction with very modest increases in tax revenue (Darby, Muscatelli, and Roy, 2005; Alesina and Perotti, 1995).
Other studies confirm the conclusion that expenditure-focused adjustments are superior. Expenditure cuts constituted three-quarters of the total efforts in sustained adjustment (Tsibouris and others, 2006) and are associated with larger adjustments (Guichard and others, 2007). Alesina, Carloni, and Lecce (2012) emphasize that large, credible, and decisive expenditure-based consolidation is less likely to cause a recession. In their analyses of the fiscal expansions and consolidation experiences of industrial countries, McDermott and Wescott (1996) emphasize that focusing on the expenditure side, especially on transfers and wages, is more likely to succeed in reducing the debt ratio than tax-based consolidation. In their studies, Giavazzi and Pagano (1990, and 1995) find that spending reductions (including cuts in transfers) and tax increases were accompanied by a private consumption boom following large fiscal consolidations. A recent study by Guajardo, Leigh, and Pescatori (2011) confirms the earlier findings of Giavazzi and Pagano (1990).
The empirical literature also finds reductions in transfer programs and government wage expenditures to be more effective than capital expenditure cuts. In particular, de Rato (2004) stresses that cutting programs that have survived in the past for economic reasons can add credibility to the fiscal adjustment and increase the probability that it will have expansionary effects. In their study, Von Hagen, Hallet, and Strauch (2002) demonstrate that adjustments that lasted longer were driven by reductions in wages and transfers, with transfers and subsidies contributing about 86 percent on average to successful cases. The findings of Nickel, Rother, and Zimmermann (2010) support this conclusion, as they report that major debt reductions were influenced by durable fiscal consolidation with a focus on expenditures, especially cuts in social benefits and public wages. Two-thirds of successful adjustments have come with spending cuts, specifically in transfers and government wages (Alesina and others, 1998). In a panel study of selected OECD countries, Biggs, Hasset, and Jensen (2010) find that reductions in non-wage expenditures and government investments contribute little to success. Heylen and Everaert (2000), however, disagree that cuts in wages will bring about a successful consolidation, and argue that government should cut transfers instead.
What Role Do External and Domestic Conditions Play?
Supportive external and domestic conditions are essential. Findings by Kumar, Leigh, and Plekhanov (2007) suggest that a supportive domestic and international growth environment facilitates adjustment efforts. Heylen and Everaert (2000) also find that the chances of a consolidation’s success rise with a favorable external environment, high economic growth, and low interest rates.
Evidence further suggests that in a federal setting, involving lower-level governments is helpful. Exploring the implications of fiscal decentralization for fiscal consolidation across the OECD countries, Darby, Muscatelli, and Roy (2005) find that involving subnational governments is critical in achieving expenditure cuts, especially with regard to reducing the overall size of the wage bill. Also, controlling grants to the subnational governments improves the success of fiscal consolidation. They note that, if fiscal consolidation is done in isolation, subnational governments behave differently; they focus on revenue increases and cuts in capital expenditure rather than on areas that are more durable in achieving fiscal consolidation.
How Does the Perception of Sovereign Risk Affect Fiscal Consolidation?
Agna and Igan (2013) analyze fiscal consolidation and corporate loan behavior in a sample of 16 advanced economies, and find that loan spreads increase with fiscal consolidation, especially for small firms, domestic firms, and firms with limited alternative sources of finance. However, when fiscal consolidations are large, the adverse effect of increasing loan spread can be mitigated, and it can be avoided altogether if consolidations are also accompanied with more adaptable macroeconomic policies and implemented by a stable government. In a study of the channel through which sovereign risk raises private sector funding costs, Corsetti and others (2012) find that if the monetary policy is constrained, the private sector’s belief that an economy would weaken becomes self-fulfilling. Further results indicate that while sovereign risk worsens the effects of negative cyclical shocks, fiscal consolidation could help curb the risk of macroeconomic instability, and even stimulate economic activity.
It is generally understood that monetary easing could be helpful in lowering interest costs, although the likelihood of enhancing fiscal consolidation has been debated. Ardagna (2004) disagrees that successful and expansionary fiscal consolidations are the result of accompanying expansionary monetary policy. Another view is that monetary policy reaction may depend on the credibility of the consolidation plan. In their study, Guajardo, Leigh, and Pescatori (2011) find that the conduct of monetary policy may differ depending on the type of adjustment, with the central bank aggressively cutting interest rates following spending-based consolidations, in turn stimulating private demand and therefore output growth.
How Does Exchange Rate Devaluation Affect Fiscal Consolidation?
Empirical findings on the impact of exchange rate depreciation or devaluation on fiscal consolidation remain largely inconclusive. There is ample evidence that the prevailing exchange rate regime determines the impact of fiscal adjustment on the economy (Giavazzi and Pagano, 1990; Lane and Perotti, 2003; Hjelm, 2002b, 2004; Lambertini and Tavares, 2005; Mati and Thornton, 2008).
In particular, Lambertini and Tavares, 2005, controlling for other determinants of successful fiscal consolidation in a study of the OECD, find that a depreciation of the nominal effective exchange rate of one standard deviation of the sample mean in the two years before an adjustment increases the probability of success by 2 percentage points. Devaluation is found to have a positive and significant impact when the adjustment comprises reductions in transfers and taxes and increases in public investment (Heylen and Everaert, 2000). Others find that exchange rate devaluation enhances fiscal consolidation and sustains growth, especially when accompanied with moderate wage increases (Alesina, Ardagna, and Gali, 1998). The impact of devaluation may depend on adjustment composition (Heylen and Everaert, 2000; Alesina, Ardagna, and Gali, 1998).
In contrast, some studies consider exchange rate depreciation or devaluation as irrelevant (Barrios, Langedijk, and Pench, 2010; Ardagna, 2004; Alesina and others, 1998; and Gupta and others, 2003). For very small open economies, Worrell (2012) argues that the depreciation of the exchange rate would not be helpful for stabilization and growth purposes, simply because these economies are different. There is a binding foreign exchange constraint and little scope for import substitution, and thus exchange rate depreciation may not increase output, since it does not enhance price competitiveness. However, while the Worrell paper acknowledges that fiscal adjustment matters, it offers little discussion of the importance of structural reforms, including reforms in the labor market, on competiveness and growth.
Are Fiscal Adjustments a Political Liability?
Evidence also suggests that, overall, fiscal adjustment may not be a political liability. For example, Alesina (2010) finds no evidence of a systematic electoral penalty or fall in popularity for governments that adopt a restrained fiscal policy. In another study, Alesina, Carloni, and Lecce (2012) find 13 changes of government and 26 “no change of government” in the elections held during periods of fiscal adjustment, which implies relatively few changes in government associated with the adjustments.
Recent events in the euro area, however, have tested the validity of these conclusions, as voters in France and Greece vented their frustrations at the polls over difficult austerity measures. It should be further noted that a coalition government is much less likely to succeed in fiscal consolidation than a single party. In a study by Alesina and Perotti (1995), out of 23 strong adjustments initiated by coalition governments, only 3 were successful. Meanwhile, the success rate for single-party governments was 64.3 percent, and for minority party governments it was 53.3 percent. This confirms the finding of Alesina and Drazen (1991) that in more polarized political systems and societies it is difficult to reach a consensus. On the other hand, Brender and Drazen (2008), in a study of a large panel of countries consisting of different subgroups, find no evidence that an increased budget deficit during an election year helps the reelection prospects of incumbents. Indeed, they find that in developed countries and established democracies, election-year deficit spending and tax cuts are punished at the polls.
What Role Do Fiscal Rules Play in Successful Fiscal Consolidation?
In the context of successful fiscal consolidation and debt reduction, empirical evidence generally associates the presence of fiscal rules with stronger fiscal performance (Schaechter and others, 2012; FAD, 2009; Guichard and others, 2007). Fiscal rules supported several large fiscal adjustments and debt reduction episodes in a large sample of OECD, G-20 and EU countries (FAD, 2009). In particular, budget balance and debt rules have improved budgetary outcomes (Larch and Turini, 2011). Evidence also points to the increasing adoption of fiscal rules, particularly as a result of the global financial and economic crisis (Schaechter and others, 2012). Indeed, the crisis provided the platform for countries to review their existing rules, complementing them with new ones. Multiple fiscal rules are now a common practice and are mostly a combination of those rules that are closely linked to fiscal and debt sustainability.
When supported with a stronger monitoring mechanism and wider coverage, a combination of budget balance and expenditure rules appears to have been more effective (Price, 2010; FAD, 2009). It is also noted that key requirements for the effectiveness of fiscal rules include transparency, flexibility, commitment, and credible punishment for noncompliance (Guichard and others, 2007; Price, 2010). Although fiscal rules have been noted to create incentives to artificially achieve targets, other supporting features have been proposed, including independent fiscal councils and fiscal responsibility laws.
Country Experiences with Fiscal Adjustment
The basis of fiscal adjustment for a sample of advanced and emerging market economies is presented in Table 5.1.
Basis of Fiscal Adjustment, Selected Countries
Basis of Fiscal Adjustment, Selected Countries
| Revenue | Expenditure | Mixed |
|---|---|---|
| Brazil, Cote d’Ivoire, France, Jamaica, Nigeria, Ireland, United States, Zambia | Canada, Chile, Finland, Germany, Lebanon, Lithuania, Netherlands, South Africa, Spain, Sweden, United Kingdom | Barbados, Denmark, Japan New Zealand, Russia |
Basis of Fiscal Adjustment, Selected Countries
| Revenue | Expenditure | Mixed |
|---|---|---|
| Brazil, Cote d’Ivoire, France, Jamaica, Nigeria, Ireland, United States, Zambia | Canada, Chile, Finland, Germany, Lebanon, Lithuania, Netherlands, South Africa, Spain, Sweden, United Kingdom | Barbados, Denmark, Japan New Zealand, Russia |
Advanced Economies
Canada, 1994–97
Before its fiscal consolidation episode, the Canadian economy was characterized by slow recovery, low inflation, a high output gap, high unemployment, exchange rate deprecation, and an improving current account balance. In the fiscal sphere, the country had a sizable deficit and debt stock, a large share of short-term debt by nonresidents, a high tax-to-GDP ratio, and expanding entitlements. A majority government was elected in 1993 with a mandate to address these fiscal concerns, and this was followed by similar election outcomes in 1994–95 in the two largest provinces.
Fiscal adjustment had an expenditure focus, complemented by some revenue measures. Expenditure reduction accounted for about 85 percent of the fiscal adjustment and covered cuts in the wage bill, unemployment benefits, defense spending, agricultural and business subsidies, and transfers to provinces. There were also cuts in the provincial wage bill, capital spending, and transfers to municipalities totaling 1.7 percent of GDP in fiscal year 1993–94. Revenue measures included higher excises, a broadening of the personal and corporate income tax bases, and increases in corporate income tax rates.
In addition, provinces raised education and health fees and excises and broadened their corporate income tax base. These measures led to an improvement in the cyclically adjusted primary fiscal balance (CAPB) of 6.6 percent of GDP over 1994–97. The period saw the introduction of a medium-term budget framework, tax reforms, pension reforms, and unemployment insurances reforms.
Denmark, 2004–05
The economic slowdown in Denmark that started in 2001 continued into the period with the unemployment rate gradually rising, although the country had a moderate level of public debt (about 50 percent of GDP), and a near-balanced budget. At the same time, the ruling center-right coalition entered the second half of its term with waning public support. Fiscal adjustment consisted of a mix of revenue and expenditure measures with emphasis on expenditure restraint, which accounted for approximately half of the 2.9 percent improvement in the CAPB over the period. Tax revenues exceeded expectations, largely owing to rising oil and gas prices, in spite of a reduction in personal income tax rates in 2004 and a tax freeze in effect since 2002.
Furthermore, caps on expenditure growth in real terms led to a gradual reduction in the expenditure-to-GDP ratio. A broader reform of governance at the subnational level, involving a drastic reduction in the number of municipalities, was agreed during the period. Notwithstanding that the ruling center-right coalition entered the second half of its term with diminishing public support, the success of the fiscal consolidation in the 1990s helped build a national consensus about the importance of prudent fiscal policies. Since 2001, fiscal policy has been explicitly guided by medium-term objectives.
Finland, 1998
By 1998, the Finnish economy had recovered from a deep recession in the early 1990s and enjoyed a growth rate well above the EU average. Nevertheless, the fiscal position was characterized by high deficit and medium-level but rapidly increasing debt, a high tax-to-GDP ratio, and expanding entitlement programs. Both of the coalition governments elected respectively in 1991 and 1995 had a clear mandate to achieve European Monetary Union (EMU) membership. Following fiscal consolidation, the cyclically adjusted primary fiscal balance improved by about 1.7 percent in 1998 and by a cumulative 10 percent of GDP over the 1992–2000 period due to expenditure reductions that accounted for about 85 percent of the improvement.
There were across-the-board reductions in social benefits, transfers to municipalities, subsidies, wages, and capital spending. In addition to the reduction in transfers from the center, municipalities also reduced their wage bills and capital spending and raised property taxes, thereby improving their fiscal balances by 2.3 percent of GDP in 1994–95. Revenue measures included broadly revenue-neutral tax reforms involving raising payroll taxes and user fees. As part of structural reforms, efforts were made to broaden the tax base, raise rates, and reform the pension scheme.
France, 1996–97
The expansionary policy response to the 1993 recession left France with a large fiscal deficit and a rapidly rising public debt, falling short of the EMU criteria. Fiscal consolidation was launched on the back of a slow recovery from the recession. However, to ensure that the new government had a clear mandate for fiscal consolidation, parliamentary elections were scheduled to be held a year earlier than usual. Fiscal consolidation was rooted in revenue measures, which accounted for more than 85 percent of the 3 percent improvement in the cyclically adjusted primary fiscal balance to GDP over 1996–97.
Revenue measures covered a broadening of the tax base, temporary profit tax surcharges, an increase in the VAT rate in 1996, and one-off dividend payments. The above measures were combined with reductions in capital spending and in health care and defense expenditures. The consolidation largely lacked support at the subnational level, although there was a public consensus that fiscal consolidation was necessary to achieve EMU membership. Proposals to reform public pensions and railways triggered protracted strikes in late 1995.
Germany, 2003–05
Germany had witnessed three years of slow growth, high unemployment, and heavy losses in the financial sector. In addition, the fiscal deficit widened to about 3.7 percent of GDP in 2002, with public debt at around 60 percent of GDP. A coalition led by the Social-Democratic Party narrowly won the elections in September 2002. In March 2003, a comprehensive, multiyear reform plan was unveiled, designed to gradually bring labor market outcomes, public finances, and the welfare system back on track by 2010. The improvement in the cyclically adjusted primary fiscal balance was in the range of 0.6–6 percent of GDP over 2003–05 mainly as a result of expenditure measures, which included reduction in health care spending, and tightened unemployment benefit entitlements. However, income tax cuts partly offset savings achieved through expenditure measures. The 2002 Internal Stability Pact failed to reach an agreement on the division of responsibilities between the central and subnational governments in compliance with the Stability and Growth Pact, and the attempts to reform intergovernmental relations ended in political gridlock. Although the proposed spending cuts were widely criticized by the opposition and by organized social groups, including the unions, voters seem to have been sharing a general sense of crisis, one requiring drastic measures.
Ireland, 2003–04
After a decade of strong growth performance, economic activity in Ireland decelerated markedly in 2002 and remained subdued in 2003. Despite the relatively low public debt, around 35 percent of GDP, and a near-balanced budget, the country undertook fiscal consolidation. Revenue measures, including increases in VAT and excises, and changes in capital gains taxation accounted for more than 90 percent of the 2.9 percent improvement of the CAPB to GDP over the period. On the expenditure side, capital expenditure was reduced, while the 2003 wage agreement moderated wages.
Structural reforms included the introduction of rolling multiyear capital expenditure budgeting and preparation of long-term fiscal projections. The central government traditionally held tight administrative control over subnational governments, although no specific adjustment measures were introduced at that level during the period. The coalition government had enjoyed a strong parliamentary majority since 2002, despite some differences of views within the coalition. Public support for fiscal consolidation was partial, with strong opposition from the trade unions. The government responded to a rapid fall in its popularity by substantially reshuffling the cabinet in September 2004, which revitalized the reform agenda.
Italy, 1997
Fiscal consolidation in Italy was preceded by electoral reforms at both the central and regional levels, which resulted in political stability. The fiscal consolidation occurred at a time when growth turned negative after a strong performance in 1995. Inflation was declining, but unemployment remained high. The debt was very high, over 115 percent of GDP in 1997, and had been rising in spite of fiscal consolidation efforts since the early 1990s. A public consensus emerged that fiscal consolidation was necessary to achieve EMU membership. Expenditure and revenue measures, approximately equally, contributed to the improvement in the CAPB by about 2 percent in 1997 (and by a cumulative 3.5 percent of GDP over 1994–97).
A number of temporary and permanent measures, including a personal income surtax, a levy on severance payment funds, and an increase in VAT rates in 1998, boosted revenues to a record high of over 47.5 percent of GDP. To lower expenditure, the government curtailed capital spending, reduced transfers to subnational governments, and halted the persistent increases in pension and health care outlays. Other reforms included tighter control over intergovernmental transfers since 1996, clearer delineation of expenditure responsibilities between the tiers of government, and electoral reform, which increased accountability.
Japan, 2004
During the fiscal consolidation episode, Japan’s economy was gradually recovering, with contributions from both exports and domestic demand. However, a decade of high fiscal deficits (about 8 percent of GDP in 2003) led to a rapid accumulation of public debt, which reached 160 percent of GDP in 2003 while social security spending kept rising. The cyclically adjusted primary fiscal balance improved by about 1.3 percent of GDP in 2004, mainly as a result of higher revenues combined with expenditure restraint.
Revenue measures included a rollback of past income tax cuts, while the higher-than-expected tax revenues were saved. A gradual reduction in capital spending, containment in the growth of social security expenditures, and across-the-board cuts in discretionary spending programs were helpful. A devolution of tax and spending responsibilities to the subnational governments led to a cut in subsidies and a modest net savings. The ruling coalition had been in power since 2000, but it lost positions in both houses of parliament in 2004 as the government’s approval rating plummeted, partly due to the passage of pension reform legislation.
The Netherlands, 2004–05
The Dutch economy had experienced a significant downturn in activity since 2000, accompanied by a sharp deterioration in its fiscal position as the 3 percent Maastricht deficit ceiling was breached in 2003. The general government balance worsened by almost 5½ percentage points during the first three years of the decade, as a result of the 2001 tax reform, increases in health care and education spending, and a higher deficit among local governments (reaching 0.6 percent of GDP). Activity began to pick up in 2004; growth was projected at about 1 percent in 2004 and 1¾ percent in 2005. The challenge was to nurture the emerging recovery while ensuring fiscal sustainability.
Against this background, fiscal consolidation was initiated by a new government and consisted mainly of expenditure measures, which accounted for more than 75 percent of the improvement in the structural deficit-to-GDP ratio. As a result, the structural deficit narrowed by about 2.3 percent of GDP over 2004–05. There were modest base-broadening tax policies, while natural gas revenues increased. Expenditure measures included a significant cut in civil service employment, a general cut in subsidies, a freeze of public sector wages and social security benefits, and a reduction in the coverage of the basic public health care package. Earlier reforms in the 1990s had established a strong institutional framework for medium-term budgeting, which incorporated long-term projections of pension and social welfare spending.
At the subnational level, there were more explicit constraints on the operation of the local governments, including limitations on how much they could borrow and a strong emphasis on closer cooperation between the central and local governments. Local governments supported the consolidation effort by improving their balances in 2004–05. The government was determined to comply with the 3 percent deficit limit. To this end, debt and deficit reduction objectives were put into multiyear perspective using a medium-term fiscal framework. The role of the Bureau for Economic Policy Analysis was seen to be important in bringing consensus on the needed measures.
New Zealand, 2003
The macroeconomic environment in New Zealand was characterized by solid and accelerating economic growth, a narrowing current account deficit, unemployment at a 16-year low, a slight budget surplus, and a moderate level of public debt (about 40 percent of GDP), which nevertheless exceeded the government’s long-term target of 30 percent of GDP. The political environment was competitive, with the opposition calling on the ruling Labor Party to introduce more tax cuts and improve the quality of health and education services. Nevertheless, following the September 2005 elections there was no significant relaxation of fiscal policy, and the incumbent party was re-elected with a confirmed mandate for continued fiscal consolidation.
Fiscal adjustment measures were mixed. Tax revenues and surpluses of public enterprises turned out to be higher than expected. Expenditure restraint accounted for approximately 40 percent of the improvement in the cyclically adjusted primary fiscal balance of about 1.4 percent of GDP in 2003 (and a cumulative 3.3 percent improvement since 2000). Caps on current expenditure led to a gradual reduction in the expenditure-to-GDP ratio. The government reiterated the importance of its commitment to the principles of medium-term budgeting established earlier (including the need to achieve an average surplus over the cycle) and emphasized the need for higher savings in the light of future pension and health care obligations.
Spain, 1996–97
Elected in March 1996, Spain’s coalition government had a mandate for fiscal consolidation. The economy experienced a relatively rapid recovery after the recession, which had culminated in negative GDP growth in 1993. However, while economic activity was on the rise and inflation gradually subsided, high unemployment (at above 20 percent of the labor force) persisted. Public finances deteriorated gradually after 1988, with the fiscal deficit exceeding 7 percent of GDP in 1995 and public debt rising rapidly to over 70 percent of GDP.
The focus of fiscal consolidation was on expenditure reduction, complemented by some revenue measures. Expenditure cuts accounted for about 60 percent of the improvement in the cyclically adjusted primary fiscal balance of about 2.8 percent in over 1996–97 (and by a cumulative 4.1 percent of GDP since 1993). Reductions in current expenditure included cuts in social transfers, the wage bill, and health care spending. Tax reforms aimed at simplifying the tax code and reducing the burden on small businesses, coupled with strengthened tax administration, resulted in a significant improvement in tax buoyancy.
Structural reforms included gradual improvements in budgeting and monitoring, privatization, a reorganization of public enterprises, and the strengthening of tax administration. In 1992, Spain adopted a cooperative approach to regulating subnational public finances, whereby subnational fiscal targets were negotiated between the central and regional governments. The fiscal consolidation enjoyed only partial support at the regional level, although there was public consensus that it was necessary to achieve EMU membership.
Sweden, 1994–98
The Swedish economy had witnessed the deepest recession since the 1930s, accompanied with high inflation, rising unemployment, and exchange rate depreciation. The fiscal deficit exploded to over 12 percent of GDP, as a result of the cyclical downturn and the underfinanced tax reform of 1990–91, with public debt reaching 80 percent of GDP. Fiscal consolidation was largely expenditure-based, complemented with significant revenue measures. Expenditure cuts accounted for approximately 75 percent of the improvement in the cyclically adjusted primary fiscal balance of about 11 percent of GDP over 1994–98.
There were reductions in pension and welfare spending, including unemployment benefits and cuts across a broad range of spending programs. The country saw increases in social security fees, full taxation of dividends and capital gains, and increases in personal income tax rates. The unemployment benefits were reformed, with emphasis on shifting from cash payments to training. In 1993, the mechanism of distributing relief grants to municipalities was revised, which alleviated the problem of soft budget constraint. The consolidation was supported at the local level in 1995 and 1997–98. Fiscal consolidation was unpopular, as reflected in the outcome of the September 1998 elections in which the ruling party suffered major losses, despite retaining the majority in parliament.
The United Kingdom, 1995–98
After 18 years of being in opposition, the Labor Party won elections in the United Kingdom in May 1997 with an overwhelming majority in Parliament. The new government confirmed the course of fiscal consolidation and introduced a number of new policy reforms, including transferring the responsibility for setting interest rates from the Treasury to the Bank of England. The economy had experienced three successive years of solid economic growth, led by private consumption. Unemployment was falling rapidly, while inflation remained relatively low. The public sector fiscal deficit had increased to over 7 percent of GDP by 1994, the debt-to-GDP ratio was on the rise and already exceeded the target level of 40 percent by about 8 percentage points.
Adjustment efforts in the period 1995–98 were focused on expenditure restraint, which accounted for about 75 percent of the improvement in the cyclically adjusted primary fiscal balance of 6.4 percent of GDP over the period. Expenditure measures included containing increases in health care and education spending. On the other hand, revenue measures covered increases in indirect taxes and some duties, while for equity reasons the VAT on some items was lowered. Advanced corporation tax rebate was abolished, accompanied by a small reduction in the corporate tax rate. There was a one-off windfall levy on profits earned by privatized utilities.
Unemployment benefits were reformed, including the institution of a “welfare work” scheme to reduce youth unemployment. However, the central government maintained its traditional tight administrative control over subnational government spending. A new government in 1997 reiterated its preelection commitment to the golden rule and its intention to reduce the general government fiscal deficit of 4 percent of GDP in fiscal year 1996–97, while at the same time implementing tax reform to encourage investment.
The United States, 1994
Economic activity in the United States had been weak, and unemployment was rising. The federal government’s fiscal situation had deteriorated rapidly with a fiscal deficit that was almost 5 percent of GDP. In nominal terms, federal debt had quadrupled over the 1980–92 period, and the debt ratio was projected to continue rising at a high rate. Consolidation focused on revenue measures and a multiyear adjustment, aimed at improving the structural deficit by 2½ percentage points of GDP over the next three years.
Measures included increases in income tax rates (on the top 1.2 percent of taxpayers) and in the corporate tax rate, and a social security tax increase for the top 15 percent of social security recipients. There were virtually no expenditure measures. In particular, there were no cuts in social and health care spending. The adjustment was carried out entirely at the federal government level. Consolidation was accompanied with intensive discussions regarding health care reform, as the costs were rising at a very fast pace and taking up sizable part of the budget. Right from the beginning, President Clinton emphasized the need to reduce the deficit, in spite of the concerns that it could further depress still weak economic activity.
However, there was a recognition that an adjustment could lead to a decline in interest rates that could outweigh the contractionary effect of the deficit reduction. The deficit reduction package was passed with an extremely narrow vote in the Congress. When the Democratic majority was lost in the 1994 mid-term elections, the President demonstrated a strong commitment to his original position of continued fiscal discipline, opposed plans by some to provide a stimulus through a large tax cut, and withstood a budget crisis in Congress in November 1995.
Emerging Market Economies
Chile, 1990–2000
Following a default on its external debt in the 1980s, Chile has since implemented strong and sustained fiscal and other economic reforms. The government reduced its debt from 54 percent of GDP in 1990 to 21 percent in 2002, owing to expenditure restraint, improvement in revenue collection, and reform of loss-making state enterprises. Privatization proceeds helped reduce debt, while real exchange rate appreciation reduced the external-debt-to-GDP ratio. Structural reform since the return of democracy in 1990 was enhanced by a high degree of political cohesiveness.
In the absence of fiscal rules, other institutional factors were useful in maintaining fiscal discipline. They included allocating more powers to the Finance Ministry than other ministries or the legislature, including over subnational finances, prohibiting the central bank from extending credit to the government, and preventing lower-level governments from borrowing. The degree of central government control over subnational finances contrasted sharply with the cases of Argentina, Brazil, and Mexico. The ban on revenue earmarking rendered fiscal policy more flexible. The country’s fiscal policy strategy has permitted it to set medium-term objectives for social development and public investment.
The central government adopted a structural balance rule, targeting an annual surplus of 1 percent of GDP. These sustained fiscal policy actions improved financial market confidence, resulting in significantly lower interest rate spreads below the regional norm. Over the period, Chile enjoyed uninterrupted access to capital markets, reinforcing confidence in its economic management and avoiding forced pro-cyclical policies observed in other countries in the region.
Brazil, 1999–2003
There was broad consensus for fiscal consolidation in Brazil, bolstered by new governments elected in 1999 and 2003. The platform for fiscal consolidation was provided by external and fiscal crises stemming from contagion from Asia, a rising current account deficit, loose fiscal policy, sharp exchange rate devaluation in early 1999, and the adoption of a flexible exchange rate. The economy also experienced low growth, inflation, increasing primary fiscal deficits at all levels of government, and a rise in public debt.
Other economic weaknesses included fiscal indiscipline at the subnational level, loss-making public enterprises, labor market rigidities, a somewhat restricted trade system, a cumbersome tax system, generous pensions, and significant budget rigidities. Fiscal adjustment was essentially revenue based, targeting increases in the primary surplus of 3 percent of GDP in 1999 and gradually to 4.25 percent of GDP in 2003, which led to the nonfinancial public sector revenues increasing by 8 percent of GDP in the period 1999–2003. At the same time, total expenditure in the nonfinancial public sector increased by 7 percent of GDP, despite measures to contain entitlement spending.
The public sector primary balance improved from a 1 percent of GDP deficit in 1998 to a 4.4 percent of GDP surplus in 2003, boosted by improvement in revenue administration, privatization, and an increasingly commercial orientation of public enterprises. Expenditure measures included efforts to strengthen the social safety net and pension reform to reduce generous benefits. The primary balance targets were consistently met throughout the period. Furthermore, there was a well-established framework for developing, implementing, and monitoring the annual budget law.
The fiscal framework was anchored in the Fiscal Responsibility Law, the constitutional provisions on public financial management, and the budget guidelines, which set targets for three years ahead on a rolling basis. All levels of government contributed to the turnaround in fiscal outcomes. There was a debt restructuring agreement between the federal and the subnational governments and legislation limiting personnel expenditures and debt levels at all government levels.
Jamaica, 1998–2001
Jamaica witnessed four successive electoral victories for the People’s National Party from 1989, including a strong majority victory in late 1997. The economy experienced high inflation and stagnant output in the early 1990s, a financial crisis in 1996–97, and a high current account deficit amidst exchange stability and lower inflation. Fiscal balances worsened by 8 percent in 1996–97, partly reflecting support for troubled financial institutions. Public debt rose to 155 percent of GDP in 2003. The interest bill was high, while wage bill pressures mounted.
Other issues included a large and growing informal sector, high crime rates, vulnerability to tourism receipts, and volatility in bauxite prices. The targeted improvement in the public sector primary balance was 7.8 percent of GDP over two years, with gains of 3.8 percent of GDP expected through tax administration, higher fuel taxes, and user fees. Expenditure measures targeted cuts in capital expenditure equivalent to 2.2 percent of GDP and cuts in non-wage goods and services equivalent to 1 percent of GDP, as well as a moderate wage increase equivalent to 0.2 percent of GDP.
The 2000 Staff Monitored Program targeted cost recovery in health and education and a rationalization of safety nets, while the 2002 Staff Monitored Program focused on enterprise reforms. The fiscal impact was an overall improvement of central government and public sector primary balances by 6.0 percent of GDP, one-third of which came from revenue gains and two-thirds from cuts in non-interest expenditures. However, while public sector primary surpluses averaged 10.5 percent of GDP during the period 1999–2000 to 2001–02, there was little scope for further improvement due to the high interest burden (14 percent of GDP) and high wage bill. The adjustment effort was derailed by revenue weaknesses, wage increases, and security and tourism spending in 2001–03.
Lebanon, 1998–2002
Lebanon’s public debt grew from 30 percent of GDP in 1992 to over 100 percent in 1997 in the face of moderate growth. Real exchange rate appreciation and lack of structural reforms affected competitiveness and export growth. These were compounded by a narrow tax base (15 percent of GDP), high spending on rebuilding the economy (9 percent of GDP per year during 1995–97), a high wage bill (11 percent of GDP), and debt service obligations. The overall fiscal deficit was 27 percent of GDP in 1997, with a primary deficit of 12 percent of GDP. Earlier adjustment had been undermined by weak support, high oil prices, and civil conflict in the south of the country. A new government in 1998 supported fiscal adjustment focused on expenditure, targeting an 11 percent of GDP reduction in the primary balance in 1998 and a 14 percent reduction over five years.
Revenue measures included higher customs tariffs, a new tax on hotel and restaurant services, higher receipts from cellular contracts, and increases in fees and excises. On the expenditure side, a 7 percent cut in non-interest spending was envisaged based on reducing public investment, transfers, and the number of teachers and contractual employees, as well as a wage freeze bill. Following the adjustment measures, the primary balance improved by 13.9 percent of GDP during 1998–2002. Revenue increased by 5.7 percent, boosted by VAT introduction in 2002. Non-interest expenditure fell by 8.1 percent of GDP, although the wage bill increased by 0.7 percent of GDP. Structural reforms included improved expenditure forecasting and tax and customs administration reforms.
Lithuania, 1999–2003
The Lithuanian economy experienced a deep recession following the 1998 financial crisis in Russia, with growing unemployment, a high current account deficit, and low inflation. Its currency was pegged to the U.S. dollar. Its fiscal deficit worsened in 1998–99, reflecting this recession as well as increased household transfers and lending to the state oil company. Other economic problems included poor expenditure management, a large stock of payment arrears, high debt burdens, labor market rigidities, energy tariffs below cost recovery, trade restrictions, and excessive agriculture subsidies. Fiscal adjustment was expenditure based, targeting reduction of the overall deficit by 5.7 percent of GDP in the first year and by 2.8 percent (to a balanced position) in the second year.
Revenue measures targeted 1.2 percent of GDP through increases in payroll taxes and fuel and tobacco levies. Expenditure reductions amounted to 4.5 percent of GDP through cuts in net lending and in household transfers, capital spending, and nominal wages. The deficit was reduced by 6.7 percent of GDP, even further than originally targeted, through larger expenditure cuts. Important structural reforms included strengthened treasury and commitment controls and the consolidation of extra budgetary funds, while the Fiscal Reserve Fund, an organic budget law, and a medium-term framework facilitated the adjustment. Low wage growth and labor market reforms improved competitiveness.
Russia, 1999–2002
In the years leading up to Russia’s fiscal consolidation, its economy had suffered major economic problems. In 1992–94, it experienced severe contraction and hyperinflation, with the inflation rate exceeding 300 percent in 1994 and output declining by 13.5 percent. The fiscal deficit increased from 6.5 percent in 1993 to 11.5 percent in 1994 due to the growth of subsidies to industry and agriculture. Following violence in October 1993, the political landscape was characterized by a succession of prime ministers and, eventually, the resignation of President Yeltsin in 1999.
The country had a severe financial crisis in 1998, defaulting on its debt, while the domestic currency depreciated. Central government tax revenues declined through the mid-1990s, reaching 9 percent of GDP in 1998 due in part to depressed oil prices. The targeted adjustment in 1999 was 2.75 percent of GDP, half from revenues and half from expenditure cuts. Tax collection from oil companies was strengthened, boosted by the introduction of new oil taxes, a rationalization of the tax structure, and high oil prices.
Although there was no specified real cut in expenditure, expenditure control was improved by limiting some ministries’ access to special funds. Transfers to subnational governments were cut by 1.5 percent of GDP and there was a further social spending reduction of 5 percent of GDP. The central government’s fiscal balance improved from a deficit of 6 percent of GDP in 1998 to surpluses in 2000–02, largely on account of revenues increasing by about 7 percent of GDP, following the recovery of oil prices and currency depreciation. The interest bill declined sharply as a result of the default, while the primary balance improved by 8 percent of GDP to a surplus of over 5 percent in 2000–02.
South Africa, 1993–2001
The economy of South Africa experienced recession during 1990–92 with high inflation, capital flight, and concerns over the transition from apartheid to majority rule. The fiscal deficit had worsened during that period by 5 percentage points, due to revenue weakness and high social spending. Public debt increased, although it remained moderate at 40 percent of GDP. There were calls for structural reforms in the labor market, trade, public enterprises, and public administration. The international trade and financial sanctions of the apartheid era were lifted in October 1993.
Fiscal adjustment adopted an expenditure focus, targeting a 4 percent of GDP deficit reduction over five years—2 percent in the first year and 0.5 percent annually thereafter. Subsequent efforts announced in 1996 targeted a further deficit reduction by 2 percent of GDP from the 1995–96 out-turn.
Revenue measures were neutral from 1994–95, with the elimination of exemptions, an extension of the tax base, and lower tax rates. The VAT rate was raised from 10 to 14 percent in 1993–94, while tax policy and administration reform continued. Expenditure measures targeted cuts in the wage bill and in subsidies and transfers, as well as a 1 percent of GDP increase in capital expenditures. Following fiscal adjustment, the overall deficit was reduced by 6.5 percent of GDP in 2002–03. Revenue gains accounted for 3 percentage points, while spending reductions amounted to 3.5 percent. The primary balance was strengthened by 6.5 percent of GDP in 1999–2000. Following the decline in the interest bill, social and capital spending were increased. Key structural reforms included base broadening and lower rates for income taxes, revenue administration reforms, a medium-term budget framework, improved expenditure planning, and management accounting.
Nigeria, 1994–2000
Nigeria witnessed many years of military rule prior to its 1999 democratic transition. There were numerous allegations of corruption, fraud, and theft during the Abacha regime (1993–98). GDP growth slowed from nearly 9 percent per year in 1988–90 to 1.9 percent in 1993 and 0.3 percent in 1994. Inflation increased over the same period, exceeding 70 percent in 1994. The overall balance weakened from a surplus of 2.9 percent of GDP in 1992 to an 11.2 percent deficit in 1993. The non-oil primary deficit was in excess of 40 percent of GDP. A dual exchange rate system, a large informal sector, corruption and weak governance, oil dependency, and subsidies were all major issues of concern.
Fiscal consolidation, which began in 1994 was revenue based. The introduction of VAT in 1993 and oil price increases during the period improved government revenue, while the removal of a fertilizer subsidy and a reduction in the wage bill moderated the rising government spending. Unfortunately, higher wages in 2000 offset the earlier reduction. The primary balance improved by 9 percent of GDP during 1995–97. Similarly, the non-oil primary balance as a percentage of non-oil GDP improved by 20 percentage points.
Barbados, 1991–93
In 1990, Barbados faced severe balance of payment difficulties caused by a bunching of external debt obligations, loosened financial policies, and a steep drop in tourism receipts. During the ensuing recession, output contracted, inflation accelerated, and unemployment worsened, while foreign reserves fell to a very low level, just 1⅓ weeks of import in September 1991. High expenditure outlays in the face of weak revenue growth further widened the fiscal deficit to an unsustainable level in 1991, while public debt remained at about 31 per cent of GDP. The country undertook fiscal adjustment and economic reforms to restore financial stability and foster conditions for economic growth.
Under an IMF Stand-By Arrangement, Barbados undertook broad-ranging economic policy measures, including major increases in taxes and charges for public sector goods and services, as well as a large scale-back in expenditures. Among other revenue measures, the consumption tax was raised three times, increasing from 10 to 17 percent; a stabilization tax of 4–5 percent was imposed; and public utility tariffs and charges were raised by as much as 75 percent. The expenditure and income policies included an 8 percent wage cut for public employees, an 11 percent cut in the public workforce, cuts in transfers to public corporations, and wage freezes. Although initially the economy contracted more sharply than expected, the fiscal deficit narrowed from 7.3 to 0.7 percent of GDP, while current account deficit also improved from 4.4 to 0.3 percent of GDP, bolstering foreign reserves.
Developing Economies
Cote d’Ivoire, 1993–2000
Cote d’Ivoire experienced political instability following the death in 1993 of President Houphouët-Boigny, who had governed for 33 years. Growth had stagnated during 1987–93, partly due to strong currency and a high and increasing public debt of more than 170 percent of GDP in 1993. The fiscal deficit was equally high at 12 percent of GDP in 1992–93. Tax revenues had declined from 20–22 percent of GDP in the late 1980s to less than 15 percent, wages were 11 percent of GDP in 1992–93, and interest bills were 9.5 percent of GDP.
Within the context of an IMF program, fiscal adjustment was revenue focused, with the primary balance targeted to improve by 5 percent of GDP in 1994, by 1.2 percent in 1995, and by 0.5 percent in 1996. Another three-year IMF program (1998–2000) targeted 1.5 percent of GDP improvement in the primary surplus. There was a maximum tariff cut from 195 to 35 percent and a VAT rate cut from 25 to 20 percent, while export taxes on coffee and cocoa were reintroduced. Tax exemptions were eliminated, a minimum 5 percent import tax was introduced, and property tax was extended. Expenditure measures comprised reductions in the real wages of civil servants, a 1.5 percent reduction in personnel, and a reorientation of spending on health, education, rural development, and basic infrastructure.
The general government primary balance improved by 10 percent of GDP, 7.8 percent due to spending cuts. The public debt ratio decreased from nearly 200 percent of GDP in 1994 to just over 100 percent during 1994–2001, reflecting lower interest payments and a lower wage bill. Key structural reforms included the creation of a large taxpayer unit and improved customs administration. Economic performance improved following the CFA devaluation, with GDP growth of over 7 percent in 1995–96, 5.7 percent in 1997, and 4.8 percent in 1998.
Zambia, 1989–1994
Zambia had high inflation and external arrears, while the fiscal deficit averaged over 11 percent of GDP during 1987–89 due to poor revenues and increasing expenditures. Structural issues included price controls, agricultural subsidies, and a large informal sector. The fiscal adjustment was revenue-based, covering measures such as removal of import tax exemptions, adjustment of personal income tax brackets, reduction of the top marginal rate, extension of sales tax, introduction of a copper windfall levy, increased fees, and mandatory dividends from state-owned enterprises.
Furthermore, a sales tax on fuel was introduced, while the collection of tax arrears from parastatals improved. Expenditure measures included reducing maize and fertilizer subsidies and reorienting spending from investment to spending on operation and maintenance and on essential goods and services. The overall balance improved by 9.6 percent of GDP from 1988 to 1998 and the primary balance improved by nearly 15 percent of GDP, largely reflecting external grants. Tax revenue improved by 4.3 percent of GDP during 1989–90 before slipping. Nevertheless, little progress was made in privatization, in reducing maize subsidies, or in civil service reform, and there was overspending on the wage bill. Also, a substantial exchange rate depreciation led to a sharp increase in the public debt ratio in 1990, and the adjustment was further undermined by drought in 1992.
The Main Lessons From Successful Fiscal Consolidations
It is easier to build broad consensus about the need for fiscal consolidation in difficult times. Fiscal consolidations were initiated during periods of economic recession or at the early stages of a recovery—periods often characterized by macroeconomic imbalances in the form of worsening fiscal deficits, high debt levels, current account deficits, high unemployment, and high inflation. More than 75 percent of the episodes in the 14 advanced countries were initiated against the background of weak growth, except in the cases of United Kingdom and New Zealand.
Significant fiscal consolidations were initiated by new governments. In particular, about three-quarters of the episodes in advanced countries were started by new governments, many with an explicit mandate for fiscal consolidation. In emerging economies, a sizable number of the fiscal consolidation episodes were started by new governments. In Brazil, for example, consensus on the need for fiscal consolidation was bolstered by new governments elected in 1999 and 2003. In South Africa, consolidation coincided with the transition to majority rule that marked the end of the apartheid era. New governments are favored to undertake fiscal adjustment because for them it comes at a low political cost, they are expected to propose new approaches in addressing existing problems, and they have scope to develop a medium-term strategy for fiscal adjustment with maximum ownership.
Fiscal consolidation based on expenditure reductions have tended to be more effective than tax-based consolidations. A probable reason is that expenditure measures reflect greater commitment, make substantial consolidation more feasible, and can lead to efficiency gains (Price, 2010). The composition of the adjustments was generally a mixture of revenue and expenditure measures, with many countries leaning toward expenditure-based reductions. Expenditure measures accounted for an 85 percent improvement in fiscal balances in Canada and Finland and 75 percent improvements in the Netherlands, Sweden, and the United Kingdom. In New Zealand, the adjustment was a combination of revenue (60 percent) and expenditure (40 percent) measures. In the wider sample considered by Tsibouris and others (2006), findings indicate that expenditure cuts made up three-quarters of the total effort in the sustained large adjustments.
In several successful episodes, spending cuts adopted to reduce deficits were associated with economic expansions rather than recessions. The more successful expenditure-based consolidations focused on cuts in transfers and wages, the so-called politically sensitive budget items. Country experiences show that expenditure-based adjustments, especially focusing on current expenditure—such as reductions in the wage bill and social spending—were more sustainable. Expenditure cuts were spread across multiple spending categories and institutions. Sizable reductions in the wage bill and social security spending and in transfers, healthcare, and unemployment benefits made important contributions to fiscal adjustment, especially in Canada, Finland, Spain, and the Netherlands.
Frontloaded adjustments emphasized revenue measures, while gradual adjustments relied on lowering primary current spending. Gradual adjustments were more successful in advanced countries and sometimes extended up to a decade, for example in Finland, Sweden, and Spain. This approach reflects efforts to anchor policy objectives within a medium-term framework with a credible commitment to adopted strategies. However, in a wider sample, including emerging markets and developing economies, frontloaded and gradual adjustments were equally likely to succeed, with enduring frontloaded cases emphasizing revenues more than the gradual cases did, particularly trade taxes and non-tax revenues.
Successful revenue measures focused on broadening the tax base and making reforms to simplify tax administration and reduce the tax burden. Base broadening measures were common in countries with more developed revenue administrations and longer periods of implementation, including Brazil, Canada, Finland, New Zealand, and South Africa. In some cases, tax reforms resulted in tax buoyancy and higher revenues over the medium term. Revenue-based adjustment was sustained when the revenue-to-GDP ratio was low. Tax measures focused on higher fees, excise taxes, and commodity taxes—as in Barbados, Jamaica, and Russia—which appear to be relatively easy to evade. Measures that relied on a narrow tax base and weak administration were unsuccessful.
Adjustment efforts were also enhanced by broad political consensus and public support. The presence of an external political or economic anchor influenced fiscal adjustments, especially in Europe in the 1990s where the need to achieve membership in the EMU was the motivating factor. In that context, the introduction of a broad medium-term strategy was important in mobilizing public support. Strong political leadership was needed to ensure continuity to fiscal consolidation, as the experiences of the United States and Japan illustrate.
Structural reforms included the introduction of medium-term fiscal policy frameworks, organic budget laws, and tax and institutional reforms. They also included reforms of healthcare, pensions, and unemployment benefits. A medium-term expenditure framework helped countries set and meet multiyear priorities and build credibility. Such budgeting reforms were implemented in Brazil, Canada, Lithuania, New Zealand, and South Africa. Expenditure management and treasury operations were strengthened in Lebanon, Lithuania, Russia, and South Africa. Some countries incorporated long term fiscal sustainability analyses into their medium-term policy frameworks. Tax reforms were also very common: Canada, Finland, and New Zealand reduced personal and corporate tax rates, eliminated exemptions, and taxed previously non-taxed income sources. Value-added taxes were introduced as well, for example in Nigeria and Russia. Several other countries strengthened tax administration, including Cote d’Ivoire, Russia, South Africa, and Zambia.
The size of the initial adjustment may determine the success of fiscal consolidation. The empirical literature finds that there appears to be a size effect in successful fiscal consolidations. The larger the initial adjustment, measured by the change in primary fiscal balance, the larger is the likelihood of success (Ardagna, 2004). In addition, initial conditions, particularly large initial deficits and high interest rates, have boosted the size and duration of fiscal adjustments (Guichard and others, 2007). Higher GDP growth matters as well, but it does not drive the success of consolidation (Ardagna, 2004).
Supportive external and domestic conditions are essential. The findings of Kumar, Leigh, and Plekhanov (2007) suggest that a supportive domestic and international growth environment facilitates adjustment efforts. Heylen and Everaert (2000) also note that the chances of a consolidation being successful rise with a favorable external environment, high economic growth, and low interest rates.
The chance of success for consolidation also differs according to political arrangements, with a coalition government being much less likely to succeed than a single-party government. Alesina and Perotti (1995) find that out of 23 strong adjustments initiated by coalition governments, only three were successful, which translates to a success rate of just 8.7 percent, while the success rate for singleparty governments was 64.3 percent.
The effects of fiscal consolidation depend on the composition of adjustment. Large, credible, and decisive expenditure-based consolidation is less likely to cause a recession (Alesina and Ardagna, 2009; Alesina, 2010; and Alesina, Carloni, and Lecce, 2012). Indeed, spending cuts led to higher GDP growth (Ardagna, 2004). In contrast, adjustments based on tax increases and cuts in public investment are not durable and are contractionary. In particular, consolidation implemented mainly through tax increases rather than cutting expenditure induces a sharper decline in private demand (Guajardo, Leigh, and Pescatori, 2011). A combination of spending cuts and tax increases was accompanied by a private consumption boom following two large fiscal consolidations (Giavazzi and Pagano, 1990).
Fiscal consolidations do come with short-term adjustment costs and have distributional effects. In contrast with previous findings, Coenen, Mohr, and Straub (2008) find that short-term costs are independent of the fiscal consolidation strategy used. However, their study further concludes that the distribution effects may be pronounced depending on the type of adjustment strategy, and in particular on the extent to which households differ with regard to their ability to participate in asset markets and their dependence on government transfers.
Summary and Conclusions
This chapter has attempted to answer many of the questions that policymakers may have in their quest to pursue a prudent fiscal consolidation strategy. It presented a comprehensive survey of a large body of mostly empirical literature on fiscal consolidation, covering industrial, emerging market, and developing economies. It also explored specific country experiences with fiscal consolidation dating back to the 1990s, examining a total of 25 case studies, consisting of 14 advanced, 8 emerging market, and 3 developing economies, including Barbados and Jamaica.
From the country experiences in regions outside the Caribbean one may surmise certain economic and political conditions and approaches that have contributed to successful fiscal consolidations. Specifically:
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Expenditure-based adjustments, especially those focused on current expenditure, were more successful.
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Both the size and the composition of the adjustment affected the probability of success.
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Adjustment efforts were enhanced by broad political consensus and public support.
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The effects of fiscal consolidation on growth depended on the composition of the adjustment.
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Expenditure-based consolidation is less likely to cause a recession.
On the empirical front, evidence suggests that large fiscal adjustments have been initiated under difficult macroeconomic conditions: sluggish growth, high budget deficits, high inflation, high unemployment, high debt, and balance of payment crises. Generally, initial conditions influence the design of the adjustment program and may determine the success of the consolidation plan as well, along with supportive external and domestic conditions. It is also generally understood that monetary easing could be helpful in lowering interest costs, although the likelihood that this will enhance a fiscal consolidation is uncertain.
Contrary to conventional wisdom, findings indicate that fiscal consolidation can be expansionary in the short term. Nevertheless, there are adjustment costs and distributional consequences. Evidence suggests that expansionary fiscal consolidation operates through wealth effects on consumption and credibility effects on interest rates. An alternative channel of expansionary adjustment emphasizes supply-side considerations through effects on labor costs and competitiveness. But, it should be noted that fiscal consolidation must be understood as part of a credible plan designed to permanently reduce a government deficit and therefore future tax liabilities.
Looking at successful fiscal consolidation and debt reduction, the empirical evidence generally associates the presence of fiscal rules with stronger fiscal performance. Key requirements for the effectiveness of fiscal rules include transparency, flexibility, commitment, and credible punishment for noncompliance. Although fiscal rules create incentives to artificially achieve targets, other supporting features, including independent fiscal councils and fiscal responsibility laws, have been adopted as well.
Finally, it is worth noting also that findings in the literature suggest that governments which undertake fiscal adjustments are not necessarily voted out of office. However, the success of fiscal consolidation differs across political arrangements—a coalition government is much less likely to succeed than a single party.
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Over the period in focus, many of the countries had fixed exchange regimes, and thus share similar features with Caribbean countries.
The majority of the studies focus on advanced economies and in particular member countries of the Organisation for Economic Co-operation and Development (OECD), perhaps due to data availability.
This draws mainly on two studies: Kumar, Leigh, and Plekhanov (2007) and Tsibouris and others (2006). Kumar, Leigh, and Plekhanov analyzed 14 cases in the OECD, including Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Spain, Sweden, the United Kingdom, and the United States. Tsibouris and others focused on large adjustments, examining a much wider sample, including Brazil, Cote d’Ivoire, Jamaica, Lebanon, Lithuania, Nigeria, Russia, South Africa, and Zambia.
The key characteristics of the expectations view is that nonstandard effects of fiscal policy are explained by the role of current policy in shaping expectations about future policy (see Bertola and Drazen, 1993).
Barro (1981) and Baxter and King (1993) distinguish the impact of temporary and permanent changes in government spending on output and real interest rates.
Typically, higher labor income taxes should reduce labor supply. Thus, one expects a permanent reduction in government spending financed by a tax cut to have two opposite effects on labor supply: the wealth effect, which reduces the impact of fiscal policy, and the substitution effect, which raises the impact; the former is expected to be dominant (see Alesina and Perotti, 1997; Barro, 1981; and Baxter and King, 1993).
The effects on labor supply may depend on the structure of the labor market. Alesina and Perotti (1997) notes that with unionized labor markets, a permanent increase in labor taxation shifts the union’s aggregate labor supply because it reduces the after-tax at any before-tax wage.