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Public Spending and Adjustment

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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A RECENT World Bank review concludes that countries receiving adjustment loans have maintained aggregate social spending and reduced defense outlays while cutting deficits. However, misallocation of public expenditures remains a problem: public sector wages and spending at the tertiary level tend to crowd out basic social services and nonwage operations and maintenance.

In the late 1970s and early 1980s, rapid growth in public spending that outpaced domestic revenues led many developing countries into fiscal crisis. Since then, a number of these countries have attempted to bring down fiscal deficits, often by reducing public spending, as part of their economic stabilization and structural adjustment programs. While such reductions are clearly necessary, across-the-board reductions and other improper retrenchments in public spending can result in unacceptable economic and social costs.

The way in which public expenditures (the goods and services governments provide to their people) are allocated has significant effects on both economic growth and the alleviation of poverty. A sound physical infrastructure, including rail and road networks, communication systems, and sewer and water facilities, promotes private sector productivity and facilitates economic growth. Publicly provided social services, especially primary and secondary education and primary health care, improve the welfare and productivity of the poor. So important are these types of public outlays in developing countries that they must be protected from across-the-board spending cuts aimed at deficit reduction.

The stabilization and adjustment programs supported by the IMF and the World Bank in many developing countries have been criticized as potentially dangerous to social sector programs. Some critics, including UNICEF, maintain that the fiscal austerity these policy-based lending programs impose has forced governments to curtail social sector spending, particularly for health and education. In addition, some donors have expressed concern that military outlays have remained exempt from spending cuts and that loans from multilateral organizations intended to support adjustment have instead been used to finance further military expenditures.

Are these claims and concerns justified? Where have the spending cuts during adjustment fallen, and what have they meant for economic growth and the alleviation of poverty? Recognizing the need to address these issues, the World Bank recently carried out a review of the changes that have taken place in the levels and composition of public spending in two distinct country groups. Annual data on various public expenditure categories from the IMF’s Government Finance Statistics were examined for 16 countries that have received adjustment lending—AL countries—and 13 that have not—NAL countries (Box 1). Two sets of unweighted average expenditure variables corresponding to the periods 1981–85 and 1986–90 were constructed to approximate the pre- and postadjustment periods across countries. This article summarizes the key findings from the World Bank’s review and their implications for policymakers in developing countries.

Patterns of public spending

Overall, the results of the review indicate that while levels of public spending have decreased, misallocation of public expenditures remains a problem. Among the positive developments have been reductions in fiscal deficits, the squeezing out of many inefficient projects, and a decline in military expenditures. At the same time, aggregate social sector spending has been protected from cuts.

There have also been negative developments, however. Outlays for important but politically less visible operations and maintenance (O&M)—such as providing drugs and supplies for health clinics and repairing roads—have been reduced. Allocations within the social sectors continue to be skewed away from high-return, equitable primary services such as primary education and preventive health care toward tertiary levels, particularly universities and hospitals. And little progress has been made in reducing excessive public sector employment.

On average, developing countries were able to reduce their budget deficits substantially during the 1980s. The AL countries—most notably Bolivia, Ghana, and Malawi—cut their deficits as percentages of GDP by half between 1986 and 1990, primarily by increasing revenues through carefully designed tax reforms. Aggregate expenditures were reduced only marginally, but expenditures net of interest dropped significantly to adjust for the rapid growth in interest payments during the 1980s.

Box 1Country classification1

Sub-Saharan AfricaAsia and the PacificEurope, Middle East, and North AfricaLatin America and the Caribbean
AL (16):GhanaKoreaMoroccoBolivia
KenyaPakistanTurkeyBrazil
MalawiPhilippinesChile
MauritiusThailandCosta Rica
Mexico
Uruguay
NAL (13):BotswanaIndiaEgyptDominican Republic
Burkina FasoMalaysiaOman
LiberiaMyanmarEl Salvador
Papua New GuineaGuatemala
Paraguay
Source: IMF Government Finance Statistics Yearbook and World Bank documents.

The data from the 29 countries used in this study are confined to central government expenditures; the operations of state and local governments, as well as public sector enterprises, are excluded. The group averages may be biased toward improved performance, since only countries with at least a minimum quantity of public finance data are in the sample.

Source: IMF Government Finance Statistics Yearbook and World Bank documents.

The data from the 29 countries used in this study are confined to central government expenditures; the operations of state and local governments, as well as public sector enterprises, are excluded. The group averages may be biased toward improved performance, since only countries with at least a minimum quantity of public finance data are in the sample.

Changes in public spending were analyzed by examining two specific aspects: first, the economic composition of the expenditures—that is, the type of outlay, such as capital, wages and salaries, and interest; and second, the functional composition, which defines the actual purpose of the expenditures—education, health care, defense, or transport, for example (Charts 1 and 2).

Chart 1Economic composition of government expenditures(percent share of GDP)
Adjustment lending countriesNon-adjustment lending countries
Expenditure1981–851986–901981–851986–90
Capital3.9

(16.3)
3.4

(14.8)
5.1

(19.9)
4.2

(17.8)
Current19.7

(84.3)
19.6

(85.5)
20.0

(79.2)
19.4

(82.6)
Interest3.2

(13.5)
4.5

(18.6)
2.0

(8.0)
2.5

(10.6)
Wages5.8

[28.4]
5.5

[30.8]
7.2

[35.1]
6.7

[36.9]
Other goods and services4.3

[22.5]
4.0

[22.0]
5.9

[20.9]
5.8

[22.8]
Source: IMF Government Finance Statistics database.Note: Numbers in parentheses are percentage shares of total expenditure. Numbers in brackets are percentage shares or total expenditures net of interest.
Source: IMF Government Finance Statistics database.Note: Numbers in parentheses are percentage shares of total expenditure. Numbers in brackets are percentage shares or total expenditures net of interest.
Chart 2Functional composition of government expenditures(percent share of GDP)
Adjustment lending countriesNon-adjustment lending countries
Sector1981–851986–901981–851986–90
Economic infrastructure1.8

[9.6]
1.6

[8.9]
1.8

[7.9]
1.5

[6.4]
Education and Health4.6

[23.5]
4.5

[25.1]
4.7

[20.4]
4.8

[22.8]
Defense2.7

[13.9]
2.3

[13.2]
4.5

[18.0]
4.0

[18.5]
Industry and Mining.39

[2.2]
.23

[1.3]
.39

[1.8]
.41

[2.0]
Source: IMF Government Finance Statistics database.Note: Numbers in brackets are percentage shares of total expenditures net of interest.
Source: IMF Government Finance Statistics database.Note: Numbers in brackets are percentage shares of total expenditures net of interest.

Economic composition

During periods of fiscal austerity, governments always find it easier to cut capital spending than to reduce current expenditures. For political decisionmakers, deferring or canceling a capital-intensive project such as a power plant or road-widening scheme is a much “softer” option than laying off government workers.

Such has been the recent experience of developing countries. One of the most important trends during the adjustment period of the 1980s was a sharp cut in capital spending as a percentage of both GDP and total expenditures, but relatively little change in current expenditures as a percentage of GDP.

Capital spending. During the early phases of adjustment, public investments were scaled down and potentially wasteful projects eliminated in a number of AL countries (Bolivia, Brazil, Chile, Colombia, Costa Rica, Côte d’Ivoire, Indonesia, Kenya, Madagascar, Morocco, Pakistan, and the Philippines). In many of these countries, reductions in investment were associated with the World Bank’s public investment reviews, which are aimed in part at identifying large projects that offer low or negative economic returns and at shifting public investment from manufacturing to infrastructure.

Côte d’Ivoire’s second structural adjustment loan program, for instance, canceled investments in a four-lane divided highway and a new, expensive university campus. And in Indonesia, many of the large, capital-intensive industrial projects initiated during the second oil boom were dropped in the 1980s.

To the extent that public investment spending, which had climbed dramatically during the 1970s, was reduced by canceling low-return projects, the initial decline in these expenditures was not wholly undesirable. But a continuing drop in public investment in some countries, such as the Philippines, is now creating infrastructure bottlenecks. There are clear indications that cuts made primarily for the sake of short-term adjustment are taking a toll on economic growth, and some countries—Morocco is one example—are now taking steps to reverse the shortfall in public investments.

Interest payments. In large measure, these reductions in capital investment occurred as countries adjusted to the increasing burden of the accumulated (and often imprudently incurred) debt of the 1980s. Although interest burdens have increased for virtually all developing countries, their growth has been particularly rapid in Latin America and the Caribbean region. The average share of interest payments in GDP for six AL countries there—Bolivia, Brazil, Chile, Costa Rica, Mexico, and Uruguay—rose 60 percent, from 3.6 to 5.8 percent, from the first to the second half of the 1980s.

Public sector employment. While the rapid growth in public sector employment and wages that was common in the 1960s and 1970s has been checked, little has occurred to reduce the number of employeesor the total spending on wages. On average, the share of wages in the budgets of both AL and NAL countries has remained constant. Many countries, including Kenya, Nigeria, and Tanzania, have responded to fiscal austerity by maintaining public sector employment. But in doing so they have reduced real wages, causing productivity levels to drop sharply. The Tanzanian civil service, for example, remains heavily overstaffed and underpaid. In only a few countries—notably Argentina, The Gambia, Ghana, and Guinea—has there been some success in reducing excessive public sector employment.

Box 2Progress in restructuring spending in Ghana

Supported by a series of adjustment loans, Ghana has progressed in restructuring its expenditures. At the start of its adjustment program in 1983, the country faced a number of severe public spending problems.

Nonwage O&M had been neglected, and public investment had declined to less than 1 percent of GDP. The result was a near-collapse of the country’s economic infrastructure, severe erosion of social services, and weak social indicators as spending for health and education dropped.

In the context of the adjustment program, Ghana made substantial progress in addressing several problems. Capital expenditures to meet infrastructure) needs had risen to about 8 percent of GDP by the end of the decade. Expenditures were restructured to increase the share of nonwage O&M in health, education, and agriculture. The share of social services (including education and health) in total expenditures increased dramatically, from 34.5 percent in 1984 to about 50 percent in 1989. Real per capita education spending increased by 150 percent between 1984 and 1989, while real per capita health expenditures tripled. The share of primary education also grew, and there was greater cost recovery and a reduction of subsidies for higher education. Basic education enrollments and a range of health indicators also climbed.

While much remains to be done, Ghana has begun to shift its spending priorities, supported by the specific measures and discussion that form part of its adjustment loan program.

Operations and maintenance. Rising interest payments and a lack of success in reducing the total cost of wages have taken a toll on spending in this category. The budgetary share of public spending on “other goods and services” (a proxy for nonwage O&M expenditures) declined in three fourths of the sampled AL countries, although these expenditures often have high rates of return; the expected return to nonwage O&M in the irrigation sector in Indonesia in the mid-1980s, for example, was estimated at 100 percent.

In many countries, important infrastructure projects and services with potentially high returns have deteriorated as a result of these reductions. A recent study concluded that neglected maintenance has left half of sub-Saharan Africa’s paved roads in only fair or poor condition. And if those currently in good condition are allowed to deteriorate, vehicle operating and future road restoration costs will increase some 270 percent.

In many of Africa’s sub-Saharan countries, including Côte d’Ivoire and Kenya, the delivery of services has deteriorated dramatically as spending on materials and supplies is curtailed to cover personnel costs. Schools are without teaching materials, health clinics lack drugs and supplies, and rehabilitated roads are once again becoming impassable. In Costa Rica, Madagascar, Pakistan, and the Philippines, nonwage O&M has borne the brunt of the expenditure cuts. Only a few countries Ghana, for example—have made concerted efforts to increase nonwage O&M for critical services (Box 2).

Functional composition

The review suggests that adjustment programs supported by the IMF and the World Bank do not impose unacceptable social costs on, or increase military spending in, developing countries, as critics have suggested.

Social sector spending. The available data reveal that aggregate spending on health and education followed similar trends in AL and NAL countries. In fact, the share of health and education expenditures in total public spending net of interest increased in AL countries, and real per capita social spending rose slightly more in AL than in NAL countries.

An examination of the individual AL countries suggests, however, that for many the allocation of expenditures within the social sector remains a problem. Although the budgetary shares of social expenditures may not have declined, intrasectoral imbalances remain and in some cases have worsened. In Bolivia, Brazil, Costa Rica, Côte d’Ivoire, Kenya, and Pakistan, for instance, resources appear to be concentrated at universities and hospitals; at the same time—and despite poor social indicators—allocations have been declining for basic social services and supplies such as drugs and textbooks, while overstating continues.

In Brazil, students pay no tuition at the public university level, although the estimated cost per student is $6,000 annually—roughly 25 times more than it is at the primary level (Box 3). In Kenya, budgetary costs per student at the university level are over 70 times higher than those for students at the primary level, and nonwage expenditures for primary education have dropped so sharply that they now amount to less than half the price of one textbook per student per year. Despite its regime of fiscal austerity, Chile is one of the few countries that has been able to protect targeted and poverty-oriented expenditures; it has, for instance, made real increases in allocations to primary education and high-quality nutrition programs for malnourished children and pregnant and lactating mothers.

To alleviate the social costs of adjustment, donor agencies and developing countries have often supported special “social funds” and “action programs” that finance short-term interventions and targeted projects. But these programs are not a substitute for the fundamental restructuring of social sector spending that is necessary to increase productivity and alleviate poverty.

Military spending. Is development assistance being used to finance military expenditures, either directly or indirectly? While some developing countries continue to allocate up to one quarter of their GDP and as much as one half of total central government expenditures to the military, most developing countries substantially reduced their military expenditures in the late 1980s. Available data for AL countries indicate that, on average, military expenditures as a share both of the budget and of GDP have declined.

These aggregate results, however, mask the relatively high levels of military spending that persist even in some AL countries. For example, there is evidence that in Pakistan and Uganda defense expenditures have been diverting necessary funds from basic social services, despite high rates of infant mortality, illiteracy, and malnutrition. It is important to ensure that basic services are adequately funded and not crowded out by high or rising military expenditures.

Box 3Spending imbalances within social sectors in Brazil

Brazil spends more per capita on social programs than many similar developing countries. Yet virtually all indicators show that the social welfare of most of Brazil’s population lags well behind that of countries with similar income levels. For instance, the average child in Brazil completes fewer than five years of schooling—the second-lowest level in South America after Bolivia. In 1989, Brazil’s infant mortality rate was more than twice that of Korea and three times that of Chile.

Brazil’s weak performance reflects the misallocation of expenditures within the social sectors. In 1986, the poor constituted 41 percent of the population but received only about 20 percent of social expenditures. Social security and urban housing, which benefit primarily wealthier groups, account for about 50 percent of all social sector spending.

In education, students pay no tuition at public universities, and the total cost of maintaining university students is close to US$1 billion per year. At the primary and secondary levels, public expenditures continue to lag, resulting in poor educational quality, high dropout rates, and low educational levels among much of the population.

Public health spending is beset with similar problems. It favors formal sector employees, the richer regions, and, increasingly, personal curative rather than preventive services. The share of total public health spending allocated to curative services rose from 36 percent in 1965 to 85 percent in the 1980s. Brazil allocates about 70 percent of its public health spending to hospitals, much more than similar developing countries and more than industrial economies.

Policy for the future

A careful scrutiny and restructuring of public spending priorities in the context of adjustment can help alleviate poverty and promote an enabling environment and infrastructure for growth. There is no single determinant of how much money countries should spend on the public sector or how they should allocate the expenditures. Rather, public spending policy should be carefully tailored to individual countries, based on a detailed assessment of need. More than a decade of adjustment experience has provided several important lessons for policymakers in developing countries, as well as for the World Bank:

• The level and composition of public expenditures should be an integral part of the policy framework of an adjustment program, as they were during Ghana’s adjustment operations, but not Brazil’s.

• During the adjustment process, adequate funding is necessary for nonwage O&M and for investment in the economic infrastructure. The Bank needs to place greater emphasis on nonwage O&M for high-return programs, while continuing its focus on public investment and civil service reform.

• Social spending policy needs to emphasize basic health and education services. Although attention to social spending in adjustment programs has increased in recent years, the instruments that have been used—social funds and action programs—constitute short-term compensatory measures only and are not adequate substitutes for the fundamental restructuring of social spending.

• Retrenchments in surplus sectoral employment are essential to reducing total spending on wages in the public sector. Adjustment lending can help cover the upfront costs of making these reductions rationally and fairly.

• When defense spending is crowding out necessary public spending, resources should be allocated away from military expenditures toward basic services. Given the Bank’s charter, adjustment loans cannot be made conditional on reducing military spending. The Bank can play a legitimate role, however, in examining the adequacy of economic and social sector spending. But the burden is on the developing countries themselves to ensure that legitimate defense needs are met cost-effectively and that allocations for key development areas are sufficient to foster growth and alleviate poverty.

For more information, see “Adjustment Lending and Mobilization of Private and Public Resources for Growth,” Country Economics Department, Policy and Research Series 22, The World Bank.

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