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World Economic Outlook analysis: How can industrial countries overcome obstacles to structural reform?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
April 2004
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Many industrial countries are in dire need of structural reform if they are to successfully address multifaceted challenges to their societies, including aging populations, rising pension and health care costs, and increasing global competition. But though the need for and benefits of reforms are widely recognized, actual reforms have frequently been less ambitious than was desirable. What are the obstacles to reform? And what can be done to overcome them? For the April 2004 World Economic Outlook (WEO), IMF staff researched structural reforms in industrial countries over the past three decades to distill lessons from past experience. One key lesson is that economic recoveries—such as the one currently under way—provide a favorable policy environment for launching reforms. Thomas Helbling of the IMF’s Research Department and coauthor of the chapter on fostering structural reforms in industrial countries, outlines this and other significant findings below.

Structural reforms have generally been associated with the notion of increasing the role of market forces, including competition and price flexibility. The term is often used interchangeably with deregulation—that is, reducing the extent to which government regulations or ownership of productive capacity affects the decision making of private firms and households. This perception clearly reflects a broad global trend during the past two to three decades, when structural reforms often focused on replacing general, across-the-board restrictions on competition and entry by new firms with more targeted, less intrusive restrictions. This broad policy shift mirrored a variety of factors, including growing evidence that not only markets but also governments can fail because of problems such as asymmetric information, management and incentive problems, and the pernicious influence of vested interests on regulatory policies.

It would, however, be misleading to equate structural reforms with the goal of abandoning regulation altogether. Fundamentally, structural reforms aim at creating institutional frameworks and regulations that allow markets to work better. Some markets are prone to market failure or inefficiency. In these situations, well-designed government regulations can prevent less than desirable market outcomes.

Labor markets, tax systems lag others

There is broad consensus about the benefits of reforming tax systems and liberalizing product and labor markets, the trade system, and the financial sector. However, the WEO’s research revealed that in all the countries included in the study (see box, page 106), some sectors were more likely to undergo more reform than others (see chart, this page). Substantial reforms were recorded in the financial sector, selected product markets, and international merchandise trade, where the very nature of the policy environment has changed in many countries. In contrast, minor reforms were made in labor markets and tax systems.

What explains these differences? The research team’s basic hypothesis was that they reflect differences in political viability. An important reason for this could be that the benefits of reforms tended to materialize over time while the costs they inflicted were immediate. More generally, some groups in society often lose out from structural reforms; lower protection from competition and increased price flexibility may, for instance, result in temporary unemployment. These groups often represent key electoral constituencies that have strong incentives to mobilize against reforms. Given the typical length of election cycles and electoral uncertainty, policymakers will choose to focus on the short-term costs of reforms while discounting the long-term benefits.

Comparing the dynamic effects of reforms on growth and unemployment across sectors, the research team suggests that the uneven distribution of benefits over time indeed played a role, as countries appear to have primarily implemented reforms that yielded the most immediate benefits with the least uncertainty. This would also explain why labor market reforms have lagged other areas. The WEO’s research team found that though labor market reforms usually increase growth and lower unemployment in the long term, they often lower growth and increase unemployment in the short term.

For other reforms, particularly of the financial sector and tax systems, the distribution of benefits was not as skewed toward the long term, and the WEO analysis also revealed two other important factors behind the sectoral differences. First, the distributional impact of reforms appears to matter. In the labor market and tax domains, reforms inflict immediate costs on more households and firms than in other areas and involve visible—and often contentious—redistribution effects. And, fiscal sustainability considerations often require that tax reforms be accompanied by politically difficult expenditure adjustments.

Second, competitive pressures can enhance the viability of reforms. Labor markets and tax systems have so far been less exposed to international competition than, for instance, product markets and trade, reflecting the limited mobility of labor and of much of the tax base. In other areas, competitive pressures have been stronger. Similarly, changes in the domestic environment can also increase competition, which, in turn, weakens opposition to reform. This is because interest groups have fewer incentives for costly political mobilization when increased competition reduces their pricing power. Unlike financial and product markets, labor markets have only recently been exposed to such pressures.

In some sectors, substantial reform efforts reduced overall restrictiveness

(Median; cumulative changes in structural policy indicators from 1975 (positive changes are reforms); distribution across 20 industrial countries)

Data: IMF staff calculations

Why have some reformed more?

Some countries have been stronger reformers than others. The WEO’s empirical analysis highlighted four reasons for the differences:

  • First, some countries’ structural policies were initially more restrictive than others’. Those countries have generally tended to reform more over the past three decades than those that started out with less restrictive structural environments. This corroborates the view that in highly regulated economies, the incentives to reform are higher than in less regulated ones because restrictions are more likely to be seen as reducing overall welfare (see chart, page 106).

  • Second, countries’ macroeconomic conditions varied. It is often argued that difficult economic conditions—especially full-blown crises or prolonged recessions—act as a catalyst for reform. The WEO’s research team found empirical evidence in favor of this “back-against-the-wall” argument during the most recent period. Difficult economic conditions made the costs of maintaining the status quo so obvious that opposition to reform weakened.

  • Third, fiscal positions were important in determining the success of structural reform. Offering compensation in the form of government transfers is a frequently used strategy to secure political support for reforms, and the scope for compensation is obviously greater when fiscal positions are strong. Industrial countries’ experiences over the past three decades confirmed that reforms were more likely to take place when the budgetary situation allowed losers from reforms to be compensated through the budget, especially in the labor market and tax systems.

  • Fourth, varying degrees of openness contributed to differences in reform efforts. Countries tended to reform more if their main industrial country trading partners had recently implemented reforms, if they were bound by international commitments, and if they were open to trade. This shows that peer pressure, exerted through international arrangements such as free trade agreements, plays an important role in reform efforts. Countries can also learn from each other, with some countries leading the way. Finally, policies of some countries that reduced competitiveness in other countries induced the latter to undertake reform as well.

Domestic product market reforms are up in response to trading partners’ reforms

Data: IMF staff calculations

How to overcome opposition to reform

Great benefits can be derived from structural reforms, especially if the reforms are packaged to create maximum synergies. However, there is often strong opposition to reform because of short-term losses to specific groups within society. Overcoming these obstacles can be difficult, and many determining factors, such as the international economic climate, are not under the control of policymakers. Nevertheless, the WEO’s research team identified four factors that help determine reforms’ success:

  • A recovery from a downturn is a good time to start reforms. Difficult economic conditions often make the need for reform more obvious, thereby weakening traditionally strong interest groups and creating a more fertile environment for reform. Historically, reforms that coincide with economic recoveries tend to be more ambitious in scope than reforms implemented during good times.

  • Since reforms feed on each other, it is important to invest political capital in launching the reform momentum. Experience shows that reforms in other areas can foster reform in labor markets and tax systems—politically the most difficult sectors to reform. Combining reforms can create important synergies and reduce short-term costs, which makes them more acceptable politically.

  • Countries should seek to improve their fiscal positions to have the fiscal flexibility needed to support reforms. Experience shows that reforms are more likely to succeed when fiscal positions allow for compensation to those most negatively affected.

  • Finally, policymakers should use outside competitive and peer pressure to advance reforms. For example, if a specific market is still relatively sheltered from international competition, it might be a good idea to open up the sector to competition before proceeding with other reforms.

Copies of the April 2004 World Economic Outlook are available for $49.00 ($46.00 academic price) from IMF Publication Services. See page 103 for ordering details. The full text of the Report is also available on the IMF’s website (http://www.imf.org).

How research was carried out

Using time series of aggregate structural policy indicators, the April 2004 World Economic Outlook (WEO) considered some important regulatory reforms that took place over the past two and a half decades in 20 industrial countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States). The study covered reforms in five areas: the financial sector, international merchandise trade, labor markets, selected product markets, and the tax system.

In each area, the indicator series categorized the degree of restrictiveness of government regulation and policies in key dimensions on the basis of actual policy instruments. Changes in an aggregate indicator provided a picture of the overall sectoral regime change. In line with the recent broad trend noted in the main text of the WEO, policy changes that reduced the degree of restrictiveness were usually considered reforms. Since the development of structural policy indicators has only recently begun, the time-series indicators were limited in scope. Nevertheless, they were helpful in illustrating broad trends and developments and in identifying determinants of reforms.

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