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IMF Advice on Fiscal Policy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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The general framework within which the Fund provides guidance under Fund-supported programs

The complex issues of fiscal policy require complex responses and, given the wide differences in economic systems of Fund members, advice must always be country specific. Many publications of the Fund describe its advice, both at the country level and more generally. This article, however, describes the framework within which the Fund provides fiscal advice to members and the reasons why certain fiscal issues are given importance.

Fiscal policy and adjustment

The accounting framework. The Fund examines economies and devises adjustment programs by creating an integrated system of national income and expenditure accounts and their associated financial flows. These accounting relationships (which are merely identities) emphasize that any sector that spends more than its income must be financed by savings in other sectors. Excess spending by the whole economy is only possible when it is financed by savings from the rest of the world—a balance of payments deficit. Typically, Fund advice initially establishes an overall desired rate of credit expansion, based on assumptions about acceptable price changes, targeted rate of credit expansion to the private sector, and, as a residual, the amount of credit available to the public sector that is consistent with the achievement of the credit and price targets.

Of course, the literature is replete with debate on the effects of fiscal policy on demand, but in most countries seeking a Fund program, it is clear that there has been an excessive monetary expansion. This monetary expansion usually stems from a fiscal deficit that the authorities are unwilling to finance except through central bank credit. So Fund fiscal advice, first, is likely to concentrate on the size and direction of change in the overall fiscal deficit.

The definition of the public sector. To see what the public sector is doing, the Fund advises putting all government transactions through the budget; in this way, a reasonable assessment can be made of the claims by and on the government, and the overall impact of fiscal policy and its financing on the economy. Basically, the staff prefers to have transparency in the budget accounts with no ex-trabudgetary accounts, arrears clearly dealt with, and few implicit subsidies or tax expenditures. Hardly any country achieves these standards. Two examples relating to central bank losses and government arrears may be instructive.

Central banks are not expected to make losses. In industrialized economies, central bank profligacy is rare. In the last few years, however, significant central bank deficits have become not uncommon in developing countries (central bank losses in Costa Rica were 5.6 percent of GDP in 1982; in the Philippines, 5.2 percent in 1984; in Uruguay, 7.6 percent in 1983; and, in Argentina, 2.5 percent in 1984). This largely occurs when a central bank undertakes quasi-fiscal activities (e.g., net lending or guaranteeing foreign exchange losses) that show up, initially, as a change in the composition of central bank’s assets.

For a fuller discussion and bibliography, see “IMF Advice on Fiscal Policy,” IMF Working Paper (WP189187), available from the author.

To try and anticipate the impact on fiscal policy of central bank losses, the Fund would suggest some supplementary indicators. Central bank losses in the profit and loss account could be amalgamated into an adjusted fiscal deficit by the addition of credit from government to the central bank. Although this might seem a simple accounting device, it puts the problem firmly through the budget and does not hide it in an off-budget account in the central bank. Also, an estimate of the size of central bank and quasi-fiscal activities could be made and shown in the adjusted fiscal deficit. Finally, further indicators could show some estimates of the value of, say, exchange rate guarantees outstanding and the losses that would result if they had to be met at the current exchange rate.

Government arrears are a growing, persistent, and rapidly changing problem in many countries. Obviously, any delay in a government payment reduces the apparent government deficit on a cash basis and forces creditors to finance government for a time. Persistent arrears cause numerous distortions in the economy. Suppliers often respond to government payment arrears by reciprocal arrears on their tax liabilities or on their payments to government state bodies (e.g., utilities or even payroll taxes already with-held). If these arrears persist, suppliers react by increasing the prices at which they are prepared to provide goods and services to government. This, in turn, increases the size of the government’s cash deficit (and the general price level). Demands for credit may increase and, hence, so may interest rates.

The Fund advice would be to undertake a firm commitment to reduce arrears as quickly as possible. Because of confused, incomplete, and inaccurate data and political and administrative constraints, the programming of arrears reduction should be combined with an appropriate monitoring system for broad aggregates of government expenditures, with arrears prevention as the primary concern.

Advice on taxation

Traditionally, the Fund tacitly appeared to accept that countries’ taxable capacity grew from primitive taxes on trade to sophisticated comprehensive income taxes. Over the past 20 years, for both stabilization and equity, the Fund has generally advised in favor of fully integrated (globalized) income taxes. It has supported the movement from schedular income taxes to global as well as customs duties with a more unified tariff structure and the removal of exemptions. It has advised in favor of broader, preferably single rate, general sales taxes. Furthermore, it has encouraged concentration on the five principal excises (alcohol, tobacco, automobiles, petroleum, and automobile spare parts) and the removal of vexatious minor excises in favor of the general sales tax.

In more recent years, reflecting preoccupations in North America and Europe, the staff has shown more interest in the so-called supply-side. Empirical assessment of the supply-side advantages of tax reductions yielded inconclusive answers; however, in general, the Fund’s advice has been to reduce very high marginal personal income tax rates, remove special exemptions, and to stop using the tax system to achieve too many objectives. The tax base should be indexed for inflation and double taxation of dividends should be eliminated. Export duties should be used sparingly, often acting as a proxy for direct taxation of agricultural income (notoriously difficult to tax), to catch “windfall” gains.

“… given the wide differences in economic systems of Fund members, advice must always be country specific.”

Broadly speaking, the Fund would like to see a corporate tax rate not too far from the maximum marginal rate for personal income tax so that tax-induced movements between personal income, partnerships, and corporations are minimized. For the same reason, the Fund would prefer this rate to be close to the capital gains tax rate. Progression is introduced through substantial differential individual allowances and this has distributional and administrative advantages.

This brings up a further and most important point. The Fund staff recognize that taxes as legislated are not necessarily those that are administered in practice. There is little point in the President, Governor, or Minister of Finance signing a letter of intent including significant fiscal policy initiatives if the Commissioners of Revenue and other administrators cannot implement those decisions, or implement them only in ways that greatly exacerbate many inequities. For instance, elaborate legislation to tax capital gains or property will do little for equity, in practice, if the income taxes as already administered affect the population in a haphazard manner.

Much of the theory underlying fiscal policy assumes that tax administration is perfect. To the extent that administration is imperfect, the anticipated effects of fiscal policy would not materialize and so the nature of the advice must change. In this case, Fund advice would concentrate heavily on improving administration.

Advice on expenditure

Goods and services. Government demand for goods and services is an addition to aggregate demand and, in conditions of excess demand, the Fund’s advice might well be to reduce government purchases of goods and services. This would be so especially if tax ratios are already high and if the recent record of government administrative efficiency in tax collection is suspect. Indeed, in many recent instances the fiscal advice preferred has been for a reduction in government expenditure on goods and services (rather than an increase in taxation) precisely because this is likely to be more directly under government control and hence easier to monitor. This, in turn, often requires improved budget expenditure control, an area in which the Fund has been giving extensive advice.

While the distinction between purchases of current and capital goods is useful analytically and is used, frequently, for the authorities’ own decision-making process, as a budgetary macroeconomic tool, it can be abused. The number of subjective discretionary evaluations of what is capital and what is current are so many that the borderline between “above” and “below the line,” and “consumption” and “investment” shifts frequently. To use such a distinction to justify current financing or borrowing puts too much weight on a fragile definition.

The largest component of government expenditure on goods and services is the wages and salaries bill. Most authorities will subscribe to the idea that they prefer a small, well-educated, highly motivated, efficient, and well-paid civil service. The least desirable option is a large, ill-educated, inefficient, and badly paid service. Yet, why do we so frequently end up with a civil service that tends toward the less desirable option? The answer is often because of political patronage, the use of the civil service as a way to reduce unemployment of either the uneducated (labor gangs) or the educated (employment of university graduates), and a political willingness to court popular votes by denigrating the civil service and its pay. One, and probably the most important, way to improve economic efficiency, in general, is to improve the efficiency of the civil service. This should mean fewer people at salaries competitive with the private sector rather than more civil servants at lower salaries. The issue should be seen clearly as one that involves not reducing the standard of living of government officers but rather improving the quality of the civil service, reducing its size, and increasing its efficiency.

Transfer expenditures. Transfer expenditures are often the most politically sensitive policy problem. Contrary to a popular canard, the Fund does not favor lower subsidies. Rather, it is in favor of making subsidies explicit and ensuring that they are properly accounted for through the budget where an annual debate can take place on their merits, size, and direction of change. Advice would concentrate on the efficiency of, say, food subsidies; how to ensure that the really poor households receive the subsidized commodities and not, for example, the urbanized middle class or the armed forces. It is not the absolute size of such transfers but their sustainability and appropriate use that is the issue.

In the longer run, the Fund is also concerned about issues such as social security in both developing and industrialized countries. The implications for and constraints on fiscal policy of the demand for social services on a pay-as-you-go financing are profound for some countries. The Fund would anticipate the future budgetary consequences of present commitments as they institutionalize and commit a large portion of future government expenditure.

Growth, prices, and distribution

Growth. The main thrust of fiscal policy advice to achieve growth is on the more efficient use of labor and capital in both public and private sectors. Advice has concentrated more on the efficient allocation of savings and investment than on their level. For the private sector, the state should stop distorting relative prices whether by the exchange rate, taxation, subsidies, or controls and regulation. For the public sector, the state should anticipate the profound changes indicated by long-run demographic trends and try to ensure that the pattern of savings and investment are not distorted through short-sighted monetary and fiscal policies.

Experience has taught the Fund staff over many years that bureaucrats do not necessarily make superior industrial managers. This does not mean that the Fund is automatically in favor of, say, privatization of publicly owned production of goods and services. It is not so much the ownership that matters but the exposure of all companies to competition. Public enterprises, however, can impose substantial budgetary burdens and can contribute to inflationary monetary expansion. Public enterprises should not have privileged access to credit and they should achieve returns that cover the opportunity cost of capital.

Frequently, the public sector has undertaken massive investment programs, often with an eye on the symbolic need to “think big.” But some of this investment may prove unproductive if the initial capital commitment is not followed up by maintenance. Donors will give capital but are reluctant to fund maintenance costs. Fund and Bank advice may well be to forego some large new projects for the sake of maintaining and operating efficiently the existing capital stock.

Prices. Efforts to finance the deficit by borrowing from the central bank may result in rapid, and escalating, price increases. The government’s reaction is often to try to suppress this by price controls. The easiest prices to control are those of publicly owned producers and user charges for government-provided services (telecommunications, electricity, education, health); consequently, these prices tend to lag behind the inflation rate. This may help consumers in the short run but leads to reduced incentives for producers to produce, an increase in the fiscal deficit, a reduction in managerial responsibility, false signals to industrial consumers of the price-controlled commodities and services, and, eventually, rationing of such inputs and administrative allocations that impair efficiency.

Governments also resort to direct control of prices in the private sector. Many of the same results occur and, in addition, the vast bureaucratic control apparatus needed to define and monitor price controls imposes substantial costs on society. Inevitably, the resulting black markets create further inequities.

The Fund generally recommends phasing out price controls in the public and private sector and controlling inflation by macro monetary and fiscal policy. Of course, this is easy to say and difficult to do. The greatest problems occur when inflation is high and accelerating. The Fund has shown considerable sensitivity in trying to come to grips with the problems of moving from high to low inflation. Indexation (which is usually only partial) is unlikely to be helpful. The final message is that shock programs and expectation changing policies cannot be a substitute for fundamental adjustment. It is the credibility of government that is crucial to breaking inflation and the root of that credibility is usually public belief that government will take tough fiscal decisions for durable and effective adjustment.

Distribution. Adjustment cannot take place without affecting the distribution of income and wealth. If Fund-supported adjustment programs imply that specific income classes (and, in particular, the poor) inevitably bear the brunt of the economic costs involved, then those programs would be both less acceptable and, in the long run, less effective than the available alternatives. The issues are far from simple. An alternative to an orderly adjustment program is often a disorderly adjustment through inflation or other economic imbalances suppressed through controls and black markets in goods and currencies. The urban poor may find goods unavailable or available only at high, scarcity-induced prices. The rural poor may find their incomes reduced by marketing boards and the rural infrastructure crumbling through poor maintenance.

Policies to help the poor—both in the long run and, in the short run, to alleviate the impact of adjustment programs—include a better allocation of credit, the expansion of labor-intensive projects, better targeted government expenditures for the poor, rationing schemes for the poor, and changes in the composition of social expenditures, e.g., skewing health and education expenditures to help the rural poor rather than the urban affluent. Direct taxes have little role to play in helping the poor; indirect taxes should be applied to goods and services (electricity, telecommunications, petroleum, hotels and restaurants) consumed by better-off households; expenditure management is probably one of the most potent weapons of poverty alleviation, although one of the more difficult in practice.

Strengths, weaknesses of advice

The discussion above emphasized the accounting framework within which Fund advice is offered. On the whole, the fiscal policy advice described derives from extensive and continuing academic and applied analysis (often published to ensure wider discussion). The staff have no particular axe to grind and the suggested policies reflect changing academic and administrative perceptions. Objectivity and pragmatism might be two slogans for this fiscal policy advice.

There are problems. First, there is perhaps too much emphasis on the size of adjustment needed and not enough on the “how.” The emphasis on large reductions in the overall budget deficit as a percentage of GNP can lead the authorities to adopt policies that are not sustainable. Yet, for the economy’s viability over the longer term, precisely what is needed are policies that can be maintained. Such policies must be acceptable. More important, they must be administratively practical.

Second, the time needed for a fiscal adjustment is sometimes underestimated. In early Fund-supported programs, one or two percentage points of GDP were considered a major budget deficit adjustment. Today, programs can contain adjustments of 6-8 percentage points. Even though programs may be longer (up to three years), or successive one-year programs stretch out the effective time horizon, nevertheless the emphasis on annual programs may focus attention on “quick and dirty” fixes. Of course, more time for adjustment requires more finance, and it is precisely the constraints on finance that are critical and contentious.

Third, the complex economic consequences of alternative mixes of revenue and expenditure measures may not be sufficiently analyzed. Undoubtedly, the efficiency of the impact of changes in fiscal deficits depends on the quality of the measures. If less efficient fiscal measures are used, the required reduction in the fiscal deficit will be larger and more severe. The Fund should integrate the traditional macroeconomic adjustment program with a carefully articulated micro-economic fiscal structural program, and also with an “investment core” (often elaborated on the basis of World Bank advice).

The Fund is aware of these difficulties and, in consultation with member countries, is elaborating more complex programs stretched over longer adjustment periods. Of course, this takes more resources and it is resources that are short in supply. Finally, the great strength of Fund fiscal policy advice is, at the same time, its greatest weakness. The Fund staff is objective. Their initial analysis is based firmly on an accounting framework. They seek to put on budget what is off-budget and to try to encourage transparency in government accounts. On this basis, evaluation of the overall adjustment needed and the optional mixes to achieve that adjustment are discussed without political bias and without any hidden agenda.

It is often precisely all these characteristics that are the foundations of criticism of policies suggested by the Fund. Fund staff are not elected by anyone and perhaps underestimate the constraints on politicians who are. Obviously, it is unrealistic to argue that the Fund must be completely apolitical. In the final analysis, agreement to programs may involve political judgments. However, such judgments are made at the level of the Executive Board. It is the function of staff to evaluate policy options and present the evidence in a dispassionate manner to enable the Board to reach its decisions on the best evidence available. Therefore, the objective and independent fiscal policy advice of the staff remains a major strength and one to be valued rather than criticized for not being what it should never be—politicized.

International Monetary Fund announces

Debt Reduction and Economic Activity

by Michael P. Dooley, David Folkerts-Landau, Richard D. Haas, Steven A. Symansky, and Ralph W. Tryon

This study, Occasional Paper Number 68, analyzes the effect of debt and debt-service, reduction on the contractual and market values of a country’s debt. It argues, by demonstrating the equivalence of five debt-reduction techniques, that the “present” value of resources offered to creditors in exchange for debt is the basic determinant of the amount debt or debt-service reduction that can be attained.

A small structural economic model is developed to quantify the macroeconomic effects of debt and debt-servicing reduction. Although care needs to be taken in drawing firm conclusions, simulations suggest that debt reduction, as part of an adjustment program, can increase the growth rate of a heavily indebted economy and increase its ability meet external obligations.

Available in English. 1990. ISBN 1-55775-135-8, vi + 32 pp. US$10.00 per copy.*

*(An academic rate is available only to full-time students and faculty of degree-granting universities and colleges: US$7.50.)

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