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External Shocks and Fiscal Policy in LDCs: Adjusting expenditures and tax policies

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1988
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Ke-young Chu

Fiscal policy in developing countries has been placed under severe strains by instability in the world economy during the past 15 years. Many developing countries, with relatively large external sectors, are highly vulnerable to the adverse impact of external shocks. Primary-commodity exporting countries have been particularly vulnerable to these shocks because of instability in world prices and hence in export revenues. There are many reasons for this vulnerability. Many developing countries have a weak tax system based on a limited number of traded goods that is directly exposed to external shocks; a decline in export earnings leads to reduced export tax revenues and indirectly to reduced taxes from economic activities deriving from exports. Import compression, on the other hand, often following a deterioration in external balances, leads to reduced import duties, excise, and other indirect taxes on imported goods. The instability in the global economic environment also contributes to fluctuations in external grants and project-related concessional loans.

In contrast to industrial countries, many developing countries have a relatively limited set of fiscal policy instruments to respond to external shocks, and, since many do not have well-developed domestic financial markets, they must finance their deficits from limited sources. An important fiscal policy issue for many developing countries, therefore, is the management of government expenditures through revenue cycles, which critically depend on external circumstances. In the short run, the narrow revenue base and limited fiscal policy instruments mean that the fiscal authorities do not have many options other than to stabilize expenditure, thereby creating instability in the fiscal balance, or to stabilize the fiscal balance by adjusting expenditure through revenue cycles. The uncertainties surrounding the timing of the fluctuation of revenue and of concessional foreign financing add to the difficulties of formulating an efficient fiscal stabilization plan.

This article discusses the impact of external uncertainties on efficient adjustment through fiscal cycles and emphasizes the importance of a long view, extending over entire fiscal cycles, in formulating and executing a fiscal stabilization plan. It also emphasizes the need for fiscal discipline and for social consensus on a policy rule to implement a fiscal stabilization plan. The focus is on broad developments in fiscal policy stance and on expenditures as a policy instrument. The article draws upon a number of recent studies, including one of fiscal policy developments in 18 non-oil developing countries over 1962-82 (see box). These results are supplemented by examples of more recent experience in a number of developing countries, including those in the sample used for the study.

This article is based, in part, on the results of a longer study “External Shocks and Fiscal Adjustment in Developing Countries: Experiences During 1962-82” by the author.

World economic environment

World economic instability in recent years has been evident in many areas. The two large increases in oil prices of 1973-75 and 1979-81 adversely affected the external terms of trade of non-oil developing countries. The steep increases in non-oil commod-ity prices during 1973-74 and beverage prices during 1976-77 were followed by equally sharp declines in 1975 and again during 1981-82. Since 1972, the exchange rates of major currencies have fluctuated widely. Large variations have also occurred in the volume of world trade, often intensifying the impact of unstable prices. Thus, the contraction of export volumes for many non-oil developing countries during the recessionary phases (1975 and 1981-82) of the two recent world trade cycles intensified the negative effects of the fall in prices on their export earnings. Meanwhile, interest rates and borrowing conditions on the world financial markets fluctuated considerably, adding to the economic uncertainty of developing countries.

Government revenues in developing countries, in general, have mirrored the unstable global environment since the early 1970s. The results of the study based on the 18 developing countries, mentioned above, reflect the rising instability of the central government fiscal balances between 1962-71 and 1972-82 (see table). The fluctuation of fiscal balances tended to be synchronized with trade cycles. Thus, the average ratio of fiscal deficits to GDP declined from 5.1 percent in 1971 to 3.5 percent in 1974 as a result of an increase in revenues, but it increased to 7 percent in 1976 following the contraction of the revenue base resulting from a reduction of external trade. Similarly, the average ratio of deficits to GDP declined, although only slightly, in 1981 before increasing in 1982 in the aftermath of the 1981-82 world recession.

The experience of many individual countries indicates even more pronounced cyclical movements in government revenues and fiscal balances. For example, in Zambia, largely reflecting the movements of the world price of copper, its major export, the ratio of revenue to GDP rose from 22 percent in 1972 to 34 percent in 1974 before collapsing to 24 percent in 1976. In Morocco, the movement of world phosphate prices was mirrored by the changes in the ratio of revenue to GDP.

The movements of overall government fiscal balances in these countries were more diverse than the movements of revenues. The timing and intensity of policy responses varied considerably; many countries reacted quickly to increases in revenues by expanding government programs, while a few used the increased revenues to improve their fiscal balance. Most countries, however, were slow in responding to reductions in revenues, precipitating a deterioration of fiscal balances.

Fiscal policy responses

The making of fiscal policy is a complex process. More than anything else, the budget is an instrument for implementing a government’s political agenda. At the same time, the political, social, and legal implications of fiscal policies hobble the government’s efforts to manage its budget. For example, certain elements of government expenditure (e.g., interest payments and pensions) may not be cut because of such implications. Other elements (e.g., military spending following an outbreak of war) are a major source of instability but cannot be avoided. The budget is also an instrument for promoting savings and investments in the private sector. Yet a major portion of government expenditure in many developing countries is allocated for public investment that is often inefficient. Further, the budget is an important instrument of macroeconomic stabilization and income redistribution.

Formulating and executing fiscal policies to achieve these varied objectives is complicated because, as discussed below, the objectives often conflict with one another.

Policy responses to an increase in revenue. During a period of large increases in export earnings and aggregate demand, the government may use fiscal policy to dampen aggregate demand by increasing tax rates or by restraining the growth of expenditures. If it adopts this cautious fiscal approach, the resulting improvement in the fiscal balance would lead to a reduction of bank financing and a slowdown in the growth of government debt. It could also lead to an accumulation of domestic or foreign assets for use during the subsequent declining phase of the trade cycle and the ensuing increase in fiscal imbalance. But although desirable for macroeconomic stability, the adoption of this cautious approach depends on the government’s ability to resist political and social pressures to greatly expand government services in a period of rising revenues. The pressure is understandably intense because of, among other reasons, the growing population in many developing countries with an increasing demand for government services. The pressure will be particularly intense if the increase in export earnings is perceived by the public to be long lasting.

Experience shows that an increase in revenue during the expansionary phase of the trade cycle, paradoxically, can be a source of fiscal imbalance if demands for increased expenditures cannot be contained. In the countries studied over 1962-82, the reduction of fiscal deficits during periods of rising revenues was brief; expenditures expanded quickly resulting in an increase in deficits in many countries. In Zambia, for example, as the ratio of revenues to GDP rose from 22 percent in 1972 to 28 percent in 1975, the ratio of expenditures to GDP increased from 35 percent to 51 percent, raising the deficit from 13 percent to 22 percent of GDP. Botswana and Swaziland were more successful in improving their fiscal balances, but Swaziland did not prevent increases in expenditures.

The structure of the increase in expenditures was not uniform among countries. For example, in Zambia, the increase in expenditures was accounted for entirely by an expansion of current expenditures. In Botswana, Morocco, and Swaziland, both current and capital expenditures were expanded.

Policy responses to a decline in revenue. Policy options during the recessionary phase of trade cycles are more limited. A negative external shock such as a decline in prices can increase imbalances in both the external and the fiscal sectors. The government can draw down financial assets accumulated during a revenue boom. In the absence of accumulated assets, the mix and the speed of policy responses depend on a variety of factors.

No imbalance, whether external or fiscal, arising from a lasting negative shock can be financed indefinitely. The government can restrain expenditures and rely on nominal and real devaluation to improve its external balance. Devaluation will increase revenue if ad valorem export and other related taxes are a dominant part of revenue. If import duties and other taxes on imported goods are dominant, and particularly if these taxes are specific in nature, much of the positive impact of the devaluation could be offset by a decline in imports and import-related taxes. The devaluation will also increase the nominal value of expenditure on government imports and foreign interest payments. Indirectly, it would also raise government spending on goods and services, including wage payments. The net impact of a devaluation on the fiscal balance depends on many factors, including the share of trade taxes in revenue, the shares of imported goods and interest payments in expenditures, the character of the tax system, the extent of domestic inflation generated by the devaluation, and the extent to which public sector wages and salaries are indexed to inflation.

The government can also attempt to increase tax revenue by raising tax rates. Experience suggests, however, that such a policy is often difficult to implement effectively as a short-run fiscal adjustment measure. First, the weakness in tax administration precludes the effective implementation of higher tax rates in many developing countries; an increase in export tax rates can lead to an increase in tax evasion, rather than tax revenue, particularly when the export industry is suffering from an adverse external shock. Second, high tax rates, even if successfully administered, weaken the external competitiveness of the economy either directly, when export taxes are imposed, or indirectly, when import duties are levied on imported inputs for export industries.

Costs and uncertainties

Expenditure cuts as an instrument of stabilization policy raise a number of issues. First, as indicated earlier, some components of expenditure (e.g., interest payments) are not within the immediate control of the authorities. Second, expenditure cuts involve economic and social costs. For example, suspending or postponing the completion of major construction projects has economic costs; reducing food subsidies has serious social costs.

18 developing countries: trends of fiscal balances and external trade, 1962-82
1962-711972-82
(Avenge over time) In percent ot GOP
Average fiscal
deficits2.85,9
(Fluctuationsover lima)1
Fiscal deficits1.425
Revenue1.31.8
Expenditure1.83.0
Foreign financing of deficit0.71.2
Exports1.73.5
Imports2.84.7
Source Based on data tram IMF International Financial Statistics various issues

Measured by rhe standard error ot the regression of each series (in percent ot GDP) on time trend; i.e.. the standard deviation of the residuals of the regression

Source Based on data tram IMF International Financial Statistics various issues

Measured by rhe standard error ot the regression of each series (in percent ot GDP) on time trend; i.e.. the standard deviation of the residuals of the regression

Both the formulation and execution of fiscal policy responses are complicated by a number of other difficulties. The first difficulty is uncertainty. Although it is easy to define a permanent shock in principle, it is not easy to recognize it in practice, much less to anticipate it. The policy responses to a shock depend on how quickly a shock is expected to reverse itself. If a shock is expected to be reversed quickly, there will be intense political and social pressure to finance the imbalance. A second problem is the time required to formulate and execute policies. Fiscal adjustment involves social choices, which in turn require the formulation of political and social consensus on these choices. Uncertainty adds to the difficulty of arriving at a consensus and thereby tends to prolong the lag between the recognition of a problem and the formulation and execution of policy measures.

The experiences of individual countries reflect the difficulty of curtailing expenditures during periods of recession and falling revenues. Thus, as the average ratio of revenues to GDP in the 18 developing countries in our study declined from 19.9 percent in 1975 to 18.6 percent in 1976, the average ratio of expenditures to GDP declined little; this pattern was repeated in 1982. The experiences of countries outside the study sample were similar. In Morocco, as the ratio of revenues to GDP declined by about 3 percentage points in 1976, the ratio of expenditures to GDP continued to increase, entirely as a result of a surge in capital outlays and external financing. In both Botswana and Swaziland, a substantial drop in revenues in 1976 did not trigger a commensurate reduction of expenditures.

Fiscal rules and discipline

A practical policy issue in stabilization programs in developing countries is how to design policy rules on the use of expenditure controls to mitigate the adverse effects of unstable revenues. It is obvious that in the long run, these countries should develop a more diverse revenue base and should develop domestic financial markets. Diversified policy instruments would be helpful in successful fiscal adjustment. In the short run, however, expenditure controls, despite their limitations, are one of the few feasible fiscal policy instruments.

One important issue in this respect is whether the fiscal authorities should attempt to stabilize expenditures or the fiscal balance. As indicated earlier, the authorities, in principle, could attempt to stabilize expenditures through the cycles of fluctuating revenue, maintaining the budgetary balance over the long run. Under such a policy rule, fluctuations in the fiscal balance would be synchronized with the fluctuations in revenues. The government would accumulate assets during the period of rising revenues and draw upon them during the period of declining revenues. In practice, however, the feasibility of following such a policy rule depends crucially on the strength of fiscal discipline to counter political pressure for an increase in expenditures during the period of rising revenues and, in the face of large uncertainties generated by fluctuating trade prices, to identify the right path of expenditures to maintain the long-run fiscal imbalance at zero.

An alternative rule would be to attempt to maintain the fiscal balance at zero by using expenditure as a policy instrument. The success of such a policy would crucially depend on the government’s ability to implement efficient expenditure cuts during the period of declining revenue, something most governments cannot do. As in the other policy rule, uncertainties would still pose major difficulties in implementing such a policy rule.

It is obvious that these two policy rules cannot be followed in their pure form. Policy options in different countries reflect a variety of economic, social, and political factors; they also change over time. The adoption of a policy rule and the implementation of the adopted rule involves political, social, and economic choices. The fact that some governments respond to a similar external shock in a more effective manner than others often reflects better fiscal discipline.

Another important issue in this connection is the efficient use of external resources. Revenue instability does not fully account for expenditure instability, part of which results from the fluctuation of the availability of foreign financing. For example, the increases in expenditure in Morocco in 1976-77 and in Swaziland in 1978 resulted from increases in capita] expenditures and coincided with surges in foreign financing.

Non-oil developing countries: trade cycles and fiscal cycles

Source: International Financial Statistics Yearbook, IMF 1987.

Conclusions

In the long run, it is important that efforts be made to diversify the revenue base and to improve the administrative capability to collect revenues. These measures would reduce the adverse impact of external shocks on revenues, and would give the government more diverse policy instruments to counteract such shocks. In addition, expansion of domestic financial markets and reduction of reliance on bank financing would enhance the government’s ability to absorb the adverse impact of external shocks without adding excessive pressure on the banking system and money markets.

Given institutional limitations, fiscal authorities cannot avoid relying on expenditures as a stabilization instrument. Even in such a setting, however, a longer-term approach to fiscal adjustment is crucially important. Policy responses should be formulated rapidly, bearing in mind their implications for the entire phases of fiscal cycles. In this sense, the management of positive or favorable external shocks is as important as the management of negative shocks. The containment of expansionary fiscal policies during periods of rising revenues is important; if the pressure for fiscal expansion is contained, the structure of the increases in expenditures would be important for efficient fiscal measures during subsequent contractionary phases.

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