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Turkey: Selected Issues

Author(s):
International Monetary Fund
Published Date:
November 2007
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III. Should Turkey Adopt a Fiscal Rule?1

A. Introduction

1. Since 2002, fiscal policy—hitherto a key source of macroeconomic volatility—has become the cornerstone of Turkey’s macroeconomic program. High primary surpluses (the “rule” under the IMF-supported program being no less than 6.5 percent of GNP) have led to sharply lower debt and real interest rates and strong private-sector driven growth.

2. Going forward, however, the fiscal policy framework may need to be adjusted. In particular, the 6.5 percent of GNP primary surplus target may become less relevant over time as debt is brought down to safer levels. The key challenge will increasingly be to manage pressures to ease the tax burden or expand public investment in a way that is most conducive to high and stable growth.

3. Thus, this chapter asks two questions: Could a formal fiscal rule help credibly reconcile the authorities’ competing medium-term fiscal goals? And, if so, what type of rule would be best for Turkey?

B. The Pros and Cons of Fiscal Rules

4. Fiscal rules are advocated in the literature as a response to excessive policy flexibility that may bias fiscal policy in practice(Kopits and Symansky, 1998).2 Due to voters’ fiscal illusion, policymakers’ opportunism, and/or other incentive problems, unconstrained fiscal policies all too often diverge from normative benchmarks, resulting in large and persistent deficits, electoral cycles, and procyclicality (especially in upturns).

5. of course, limiting policy flexibility has also costs. These may be especially high when monetary policy discretion is also curtailed (e.g., in a monetary union). Rules may directly promote procyclical fiscal policies—e.g., a deficit ceiling may require a contractionary response to a recession-induced revenue shortfall. Finally, the need to abide by numerical rules may also lead politicians to low-quality measures and creative accounting.

6. Many countries have introduced fiscal rules over the past two decades. For example, in a recent survey, the European Commission (2006) (henceforth, EC) finds that, at the different levels of government, 60 numerical fiscal rules were in place during 1990-2005. Moreover, over the past 20 years, fiscal rules have increased steadily both in number and in terms of the share of general government covered in each country (the latter grew from an average of 25 percent in 1990 to 75 percent today). Presently, almost all EU members have some form of national fiscal rule. Outside the EU, IMF staff research (FAD, forthcoming) identifies 11 other countries as having some form of fiscal responsibility legislation, including several emerging markets (e.g., Argentina, Brazil, Colombia, Ecuador, Panama, Pakistan, and Peru).

7. Fiscal rules are usually found to be associated with better fiscal outcomes. While causal interpretations of regression results is complicated by potential endogeneity problems (jurisdictions with greater backing for prudent policies are more likely to introduce fiscal rules) the evidence does seem to point to beneficial effects of fiscal rules. For example, EC (2006) finds a significant reduction in the ratio of cyclically adjusted primary expenditure to GDP in the years following the introduction (or tightening) of an expenditure rule. Daban and others (2003) emphasize improved public finances in Finland, the Netherlands, and Sweden following the introduction of spending rules. In the same vein, Poterba (1996) shows that United States states with balanced-budget rules have smaller deficits on average.

8. The cross-country experience offers important lessons on which features increase the effectiveness of a rule. Rules should: (i) build on a prior record of sound policies (e.g., Australia, Brazil, the United Kingdom, and New Zealand), rather than attempt to “buy” policy credibility (FAD, forthcoming);3 (ii) be easy to understand and monitor (with unambiguous definitions, clear attribution of responsibilities, and well-defined escape clauses); (iii) be supported by transparent and reliable data and strong public financial management systems (FAD, forthcoming); (iv) set out realistic targets, functional to ultimate policy goals, and consistent with other policy objectives; (v) come with prespecified (and, if possible, automatic) sanctions for noncompliance; (vi) be enshrined in suitably high-level legislation (EC, 2006); and (vi) avoid introducing its own biases (e.g., incentives to shift operations off-budget or play with definitions and accounting standards, and procyclicality).

C. Should Turkey Adopt a Fiscal Rule?

9. Since the 2001 crisis, the fiscal position has improved markedly, however the task of shifting it to safe ground is not yet complete. In the run-up to the 2001 crisis, a secular increase in deficits led to a fast buildup of debt (Figure 1). Moreover, fiscal policy turned increasingly discretionary, adding to macroeconomic volatility and hampering long-run growth (as showed by Mody and Schindler, 2005).4 Since 2002, as the government has progressively delivered on its commitment to achieve high primary surpluses, interest rates have declined, growth has picked up, the lira has appreciated, and debt ratios have declined by more than 40 percentage points (helped as well by high privatization receipts). Even so, debt remains high compared to other countries, constraining further improvements in credit ratings and risk premiums (Figure 2).

Figure 1.Turkey: Fiscal Policy Biases Through 2001 1/

Sources: General Directorate of Public Accounts for Turkey; IMF, World Economic Outlook; Central Bank of Turkey; World Bank, Database of Political Institutions; and IMF staff estimates.

1/ Data for overall balance, primary balance, and fiscal stimulus refer to consolidated budget. Gross debt data are for central government. General Directorate of Public Accounts. Available via internet at: http://www.muhasebat.gov.tr/indexE.php

2/ Backward-looking five-year standard deviation (in percent) of error terms from a regression of increase in real government spending over its lagged value, lagged GDP growth, change in terms of trade, and a time trend. See IMF, Mody and Schindler (2005) for details.

3/ Output gap: positive means potential greater than actual. Sample 1990-2001. Central Bank of Turkey.

4/ Fiscal stimulus is defined as the change in the cyclically adjusted primary balance.

Figure 2.Turkey: Recent Improvements Still Leave Turkey’s Debt High from a Comparative Perspective, 1993–2006

(Percent of GDP, unless otherwise indicated)

Source: Bloomberg; S&P; IMF, World Economic Outlook; and IMF staff estimates.

1/ Interest bill divided by previous year’s debt stock, in percent.

10. Looking further ahead, a transition to a lower primary surplus may nevertheless be justified—although this process needs to be managed carefully. As debt and interest rates decline, lower primary surpluses should become affordable. Yet, after several years under a de facto 6.5-percent-of-GNP primary surplus rule, market participants might interpret any loosening of the primary surplus target as a return to the discretionary and volatile fiscal policies of the past.

11. From this perspective, a fiscal rule could help. A formal rule, and the associated communication and transparency requirements, could anchor market expectations during the transition. If well-designed, it could also support key medium-term fiscal priorities, such as rapidly reducing public debt towards relatively “safe” levels and lowering Turkey’s heavy tax burden.

D. What Kind of Rule Should Turkey Adopt?

12. Deficit-based rules have some advantages, but also important drawbacks. On the positive side, they directly constrain debt accumulation. In the special case of a primary surplus-based rule, there would be the added benefits of public familiarity and strong prior track record over the past few years. On the negative side, however, these rules can be procyclical, unless either complicated cyclically-adjusted or multiyear targets are introduced, which would come at the cost of a significantly more complicated monitoring and thus lower credibility of the rule.5 Moreover, these rules may not prevent—in fact, they may actually encourage—a further worsening in budget quality since, in the face of growing expenditure pressures, the targets could be secured with ad hoc revenue measures.

13. While affording only partial control on debt accumulation, a spending rule could ensure that fiscal space is created to lower particularly distortive taxes (Box 1).6,7 A spending rule has inherent merits. First, expenditure-based consolidations may be more sustainable than those based on tax increases (Alesina and Perotti, 1996). Second, since (primary) spending is directly controlled by the government, the latter’s accountability is maximized. Third, under a spending rule incentives for optimistic revenue projections are minimized, and ex-ante monitoring of compliance is thus made easier.8 In Turkey’s case, a key virtue of a cap on spending growth is that it would focus politicians and the general public on the need for rigorous expenditure prioritization and rationalization, an essential prerequisite to create room for tax cuts while reducing debt in an environment of growing demand for income-elastic public services (e.g., health and education). Moreover, differently from the case of a deficit-based rule, failing to adjust a spending rule for the cycle would not be too costly in practice, since cyclical spending (e.g., unemployment insurance) is quite small in Turkey.

14. A key issue to address is whether investment should be covered by the rule. A comprehensive deficit or spending rule could penalize investment spending, as this is usually less costly to curtail when adjustments are needed. Hence some countries exclude public investment from their fiscal rules. On the other hand, such “golden rules” may lead to opportunistic reclassification of current into capital spending, thereby creating scope for debt accumulation.

E. What Should Turkey Do to Make a Fiscal Rule Credible?

15. Turkey’s public financial management system and fiscal transparency should be strengthened before introducing any rule. Turkey needs to implement fully the new Public Financial Management and Control law and improve budget reporting to strengthen financial management and control systems. Increasing fiscal transparency is also critical for the public to assess compliance with a rule, especially if the latter were complex.

16. An independent fiscal council could be put in charge of monitoring compliance with the rule. EC (2006) documents that among the EU members there are several independent institutions/councils explicitly charged with monitoring compliance with existing fiscal rules ex ante (budget plans) and/or ex post (budget implementation).9 These institutions can increase the reputational cost of noncompliance for policymakers. Indeed, EC (2006) finds that these councils can influence fiscal policy for the better, especially through their impact on public debate, provided its members’ financial independence, integrity, and professional qualifications are guaranteed.

17. The rule could be enshrined in high-ranking legislation. However, there is a trade-off between increasing the strength of the rule and allowing for flexibility as circumstances change. Flexibility could be introduced by allowing the government to set new caps at the start of each legislature. These would then last for the duration of the legislature (normally, 5 years), unless escape clauses are triggered.

18. Sanctions could also be considered to increase costs (reputational and otherwise) of violating the rule. Financial sanctions could be difficult to enforce on a sovereign State, unless it is bound by supranational treaties (e.g., the EU). The extent to which personal sanctions can be levied on responsible officials depends on the legal context (cross-country experience shows that personal sanctions are rare, but not unheard of—they are envisaged, for example, in support of Brazil’s Fiscal Responsibility Law). At a minimum, any rule should be supported by requirements (akin to those imposed on the central bank under the inflation-targeting framework) for the government to issue open letters explaining any failure to stay within spending or deficit limits as well as describing proposed remedial measures.

F. Conclusions

19. In sum, a fiscal rule could help, but should not in itself be viewed as a panacea. A rule with appropriate mechanisms to monitor its compliance should deliver predictable policies, thus allowing further reductions in debt and risk premiums, thereby contributing to macroeconomic stability. Ultimately, however, the cross-country experience shows that, no matter how well designed, a fiscal rule cannot by itself deliver strong fiscal performance if the government and the population at large are not fully committed to it.

Box 1.Spending Restraint and Fiscal Space

It is proposed that a spending rule be parameterized based on an implicit debt target. This would ensure that fiscal policy continues to support a reduction in the net debt ratio toward “safe” levels, which the literature puts somewhere below 30 percent (40 percent for gross debt).

As the three illustrative scenarios below show, for a given (implicit) debt target (e.g., 27.5 percent in net terms by 2012), there is a trade-off between spending restraint and room for revenue-losing, but efficiency enhancing, tax cuts:

  • Spending continues to grow faster than GNP (Panel I): In this passive scenario, meeting the debt target would require maintaining the existing revenue ratio, leaving no room for revenue-losing tax reforms.
  • Spending growth is kept in line with GNP (Panel II): Here fiscal space would be created to allow payroll tax cuts of some 6 percentage points in 2009 and an additional 10 percentage points in 2010. Financial transaction taxes could also be eliminated by 2010.
  • Real spending growth is kept below GNP growth for the next few years, say, at 4 percent (Panel III): In this active scenario, more aggressive tax cuts would be affordable (payroll taxes could be cut by 22 percentage points) while still meeting the overall debt target.

Fiscal Space for Tax Reforms under Alternative Assumptions on Spending Growth 1/

(Percent of GNP)

1/ All scenarios are consistent with achieving a net debt ratio of 27.5 percent by 2012.

The above scenarios, which envisage some relaxation of the fiscal stance over the medium term, are subject to risks. First and foremost, even though lower primary surpluses could become affordable starting from 2009 onwards on debt sustainability grounds, such relaxation of the fiscal stance may not be advisable if inflation continues to remain above target or the current account deficit fails to settle firmly on a declining path. In terms of other risks, on the positive side, these scenarios assume no privatization receipts after 2007, no revenue buoyancy, no increase in formalization from cuts in payroll taxes, and a high real interest rate (10 percent). Faster debt and risk premium reductions, because of higher privatization receipts or a more favorable macroeconomic environment, could make larger tax cuts affordable. On the negative side, heavier spending pressures or a combination of adverse shocks would quickly worsen the debt dynamics, making tax cuts potentially unaffordable.

References

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1

Prepared by Davide Lombardo.

2

For the purpose of this chapter, a fiscal rule is a permanent constraint on fiscal policy, expressed in terms of a summary indicator of fiscal performance, such as the government budget deficit, borrowing, debt, or a major component thereof (Kopits and Symansky, 1998). Hence, this chapter does not address the questions related to the desirable characteristics of budget formulation/approval/implementation, which have been shown to have potentially important effects on budgetary outcomes—see Von Hagen and Harden (1995), Gleich (2003), Fabrizio and Mody (2006), and references therein. For Turkey, a good reference on these matters is IMF (2006).s well.

3

A case in point is the failure of Argentina’s 2001 deficit rule, a last attempt to restore market confidence in the face of a quickly deteriorating fiscal outlook.

4

In addition to 2001, there were sharp contractions of economic activities in 1994 and 1999 as well.

5

On this basis, Fatas (2005) argues strongly against cyclically adjusted-based rules.

6

Dában and others (2003) advocate an expenditure rule for France, Germany, Italy, and Spain, possibly supplemented by a medium-term debt target, based on the need to reduce these countries’ high tax burden.

7

For some preliminary considerations on the design of a spending rule for Turkey, see Box 1

8

Anderson and Minarik (2006) lean in favor of spending rules over budget deficit rules mainly for this reason.

9

These are the High Council of Finance in Belgium, the Economic Council in Denmark, the State Audit Offices in Estonia and Hungary, the Cour de Comptes in France, the Courts of Auditors in Spain and in Portugal, the National Institute for Economic Research in Sweden, and the National Audit Office in the United Kingdom. The functions of the other institutions (there are a total of 23 in the EU) range from analyzing proposals to designing or vetting the budget’s macroeconomic framework. In the case of Turkey, the IMF-supported programs have, in the eyes of market participants, served as anchor and monitoring device of the “primary surplus rule.” The current Stand-By Arrangement is, however, slated to expire in May 2008.

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