Chapter

4 Budgetary and Tax Reforms, Institutional Requirements, and Fiscal Policy

Editor(s):
Richard Bart, Chorng-Huey Wong, and Alan Roe
Published Date:
September 1994
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Alan Tait

In my talk today, I will review some of the most important aspects of the IMF’s stance on fiscal policy. The IMF typically adopts a strong national accounting framework as the basis for designing its programs. This framework produces a series of accounting relationships that are basically identities. The really interesting economic issues are concerned with the movements through time of accounting relationships that are the main macroeconomic variables in dynamic models. However, the IMF starts with an accounting framework, and this focus explains why IMF mission members ask so many tedious questions—to get the statistics right. This data framework, which is accepted by both country authorities and mission teams, is based on the principal monetary and fiscal figures.

Since the IMF’s original mandate was to help members resolve balance of payments problems, the organization works backward from the payments target to set credit creation targets for both the private and public sectors. It is clear that any budget deficit must be financed by increased net borrowing from abroad, from the banking system, or from nonbank domestic sources. Typically, the IMF will suggest a rate of overall credit expansion that is based on several factors: acceptable price changes; a desired growth rate; a targeted rate of credit expansion to the private sector; and, as a residual, the amount of credit available to the public sector.

The debate on the effects, or lack of effects, of fiscal policy on demand fills the literature. Broadly speaking, in most of the countries seeking IMF support, it is generally clear that monetary expansion has been excessive. This monetary expansion, in turn, nearly always stems from a fiscal deficit that the authorities have been unwilling to finance by any means other than central bank credit. So the aspect of the IMF’s fiscal advice that I would like to concentrate on relates to the size and direction of change of the overall fiscal deficit.

Defining the Deficit

This discussion requires an understanding of what the public sector budget actually comprises. Basically, the IMF holds an ideal view (which is never met) that all government transactions should be made through the budget, because only in this way can the claims by and on the government be reasonably assessed and the economic impact of fiscal policy and its financing judged. The expression often used in this context is “transparency,” something the IMF likes to see in fiscal accounts. No country in the world ever achieves complete transparency, however, suggesting that governments frequently prefer fog to a clear view.

Off-budget items, of course, are always a source of potential difficulties. Extrabudgetary funds (EBFs), which tempt authorities to create personal fiefdoms that circumvent the usual budgetary channels, are also a serious problem. For example, in one country, over 40 EBFs were discovered. Repeated efforts were made over the next ten years to get these items on the budget. Finally, around half had been placed on the budget, but the authorities skillfully managed to retain the rest, and their budgetary accounts, of course, did not tell a complete or accurate story.

Let me mention three examples of items that should appear on a budget but often do not. The first involves central bank losses. The idea that a central bank could lose money seems almost a contradiction in terms. However, many central banks are incurring very substantial losses indeed, because they have undertaken functions they are not meant to assume. These functions may include underwriting foreign exchange losses for both state-owned and private sector enterprises. In some instances, central bank losses that were being concealed or that may never have been anticipated materialize unexpectedly as claims on a budget. The suddenness with which these losses can appear makes the resulting deficit problems particularly troublesome.

Government arrears are another major problem in many countries, particularly those of the former Soviet Union, where massive debts are building up, not only in the central and local government payments systems but also in the public enterprise system. Persistent arrears cause numerous economic distortions and can, if allowed to grow too large, affect an entire economy and threaten a government’s legitimacy. The complexities of the accounting involved then become immense, and unwinding the arrears becomes a major problem.

The third example involves credit subsidies. Official credit programs frequently offer more lenient terms than those available in the private credit market. Loans made under these programs contain both a pure loan component (reflecting the government’s role as financial intermediary) and a pure grant component (reflecting the government’s role as distributional agent). Disguising these subsidies as loans does not change the fact that they are still subsidies financed by taxes, borrowing, or monetary growth. And they are often extremely large. Even the United States, committed as it is to free market principles, had an estimated $1.32 trillion of subsidized credit outstanding in 1988—the equivalent of 29 percent of GDP.

Economies in Transition

The transition economies are proving to be extremely difficult cases for the IMF. Their situation suggests that using the budget deficit as a program target may not always be appropriate. For instance, in many of these countries it is extremely difficult to determine what is in the public sector and what is in the private sector. The means of production are largely publicly owned, so the number of state enterprises is huge.

These enterprises have many responsibilities that fall to the government in other economies. For example, state-owned firms not only employ workers but engage in “overstaffing,” retaining people who should be receiving unemployment benefits from the public sector. They may also supply pensions, housing, training, and even kindergartens. Many of these functions should be transferred to the public sector proper if the transition to a market economy is to succeed. And transferring these responsibilities means, of course, increasing the public sector deficit.

If an IMF-supported program has as a major element reducing the public sector deficit, the country involved can, of course, slow the transfer of these activities from state-owned enterprises to the public sector. But such slowdowns only underscore my point that using the measurement of the deficit as the overall adjustment target may produce perverse reactions by creating an incentive to slow reforms that most people want to see take place.

Another problem in countries in transition is high inflation. The interest rate plays an extremely important role here. To maintain positive real interest rates—as the IMF generally recommends—a country must sometimes raise nominal rates to extremely high levels, adding substantially to budgetary expenditures. Therefore, to meet the budget targets, governments deliberately do not increase nominal interest rates to reflect the true cost of borrowing, and the adjustment process is once more frustrated by concentration on the deficit target.

A final example is unemployment. Adjustment almost always involves a major relocation of capital and labor. Many economies in transition have seen output and GDP fall 30 percent, and yet unemployment has not risen above 5–10 percent. In general, such a large drop in output would be accompanied by unemployment figures unparalleled since the Great Depression (25–30 percent) but unemployment simply is not rising. Why? The answer has to do with the overstaffing mentioned earlier. Because the costs of social adjustment are so huge, state-owned enterprises continue to employ their workers despite falling output, so that productivity is also declining sharply. Adjustment is not taking place in part because the costs of funding unemployment through the budget would make the budget deficit insupportable.

Taxation Guidelines

I will turn next to some tax issues and discuss what the IMF recommends in terms of structural adjustment in tax systems. Broadly speaking, the IMF favors global income taxes and supports the move from a schedular to a global tax system. That said, it is often worrisome that many countries more or less adopt the tax legislation of, for example, a G-7 country without fully taking their own circumstances into account. The tax legislation of a Western economy may be far too complex for a nonindustrial or transition economy. Corporate income tax laws are extremely complicated, requiring resources in terms of accounting that some economies can ill afford. A large accounting firm in London estimates that for every one accountant it employs to deal with the value-added tax (VAT), it employs 15 to deal with corporate profits taxes. This sort of complexity involves high costs, not only of administration but also of compliance.

The IMF also supports a unified tariff structure, the elimination of exemptions, and simplified incentive structures, particularly in corporate taxation. Industrialists usually argue that corporate tax rates should be lower and that corporations should be offered more exemptions and incentives. In contrast, the IMF argues that simplification is essential; that incentives are distortionary; and that in creating exemptions, governments sacrifice revenue, which must then be replaced through higher taxes on other sectors. Frequently, the end result is that the more modern and productive economic sectors must support the outdated and less efficient.

In terms of a personal income tax system, the IMF strongly supports reducing high marginal personal income tax rates; simplifying the code; removing special exemptions; and not using the tax system to achieve too many social objectives. The primary functions of a tax system are to provide the government with sufficient revenue to carry out its mandate and to collect this revenue in the least distortionary way. In essence, the IMF advocates relying on broad-based excises and sales taxes. Eliminating minor excises allows a government to concentrate on the areas that provide the bulk of the revenue: alcohol, tobacco, automobiles, spare parts for automobiles, and petroleum.

The sales tax should have few rates, since its function is to raise revenue and not to achieve social and distributional objectives through differential rates, special exemptions, or varying thresholds. The distributional elements of the budget are best achieved through the personal income tax, wealth taxes, and the expenditure side of the budget. Broadly speaking, it is most efficient to make distributional improvements through targeted expenditures, transfers, and subsidies, making sure that both transfers and subsidies are in the budget and that their mandates are renewed annually by the elected representatives. The income tax system should be kept as simple as possible, since allowing numerous exemptions and providing for special cases will result in a highly distorted system with heavy administration and compliance costs. Broadly speaking, again, the corporate tax rate should not deviate too much from the maximum marginal rate for personal income tax, so that any tax-induced movements that occur between personal income partnerships and incorporated businesses are kept to a minimum.

IMF economists advising member countries on taxation have a pragmatic outlook. Although they keep abreast of the literature on optimal taxation, general equilibrium models, and public choice theory, they recognize that the legislated tax system is not necessarily the one that is administered. One of the more striking features of tax administration in many countries is that the existing bureaucracy may simply be incapable of administering the legislated tax system. The personal income tax may be widely evaded or even selectively administered. It is important to look at the actual administration of taxes (and expenditures), since no IMF-supported agreement can succeed unless a country has the ability to carry it out. An adjustment program can be predicated on improved collection of a progressive personal income tax, but the reality may be that such revenues cannot be collected because the tax administration is poor. Even worse, the revenue may be collected, but in such a selective way that inequity is increased. The tax code may specify that income from all sources be taxed, but the tax administration may be able to deal effectively only with a withholding tax on bureaucrats’ salaries, simply because it is easy to collect. Taxes on, say, professional and management incomes are much more difficult to collect, and raising these tax rates without collecting the money may increase inequity.

Guidelines on Expenditure

The IMF has no overarching theory on what constitutes appropriate government expenditures. However, most IMF economists are wary of making the distinction between current and capital expenditures in the budget. This distinction has often been misused in mandating expenditures that should not be undertaken because they are financed by borrowing rather than by current revenue or are otherwise inappropriate. The line between current and capital expenditures is so uncertain and so easily manipulated that this classification should not be given too much weight in the budgetary process.

It is more interesting to look at total government expenditures, total revenues, and the means of financing. What is important in macroeconomic terms is the deficit, its financing, and the sources of that financing. For instance, I am not happy about treating the proceeds of privatization as current revenue, but I recognize that if they are expected to continue for some years, they have many of the attributes of current revenues. If privatization produces one-time windfalls, however, they should be treated as a means of reaching a specific goal, such as reducing the national debt, rather than as a current revenue base.

Wages and salaries, another major issue, are also a principal component of most budget accounts. Often, these expenditures go to supporting a large, poorly educated, inefficient, and badly paid civil service. The desirable option, of course, is a small, well-educated, highly motivated, efficient, and well-paid civil service. Why is it so difficult to reduce bloated bureaucracies? Frequently, the answer is political patronage or the fact that the civil service is being used as a way to reduce unemployment. The uneducated may be employed in state-owned enterprises, while the educated may view public sector employment as a way to guarantee all college graduates a job. The IMF does not argue that adjustment can be brought about only by cutting wages; true adjustment may involve reducing the size of the civil service, improving the lot of government officers, and increasing the wages of a small, highly motivated, and efficient public service. But this ideal picture usually differs somewhat from the political reality.

A popular canard holds that the IMF favors lower subsidies. In fact, as I have pointed out, the IMF favors transparent, fully budgeted subsidies mandated annually by elected representatives. The IMF’s advice regarding subsidies and structural adjustment is that governments should concentrate on improving the targeting and efficiency of, for instance, food subsidies, as well as on gaining some sort of budgetary control over the subsidy position.

There is also the question of interest payments, which make up a complicated aspect of the expenditure program, particularly in countries with high inflation. Which interest rate should be used to define the budget deficit? Should the nominal interest rate be used, or an element of that rate, i.e., compensation to debt holders for capital losses in a high-inflation period? Should only the real element in interest rates be used? IMF economists recognize the distinctions, and, indeed, they usually note in all documents the distinctions between different definitions of the budget—i.e., the cash deficit, the operational deficit, and even the intertemporal deficit. However, because of the IMF’s focus on a strong accounting framework, which I mentioned at the very beginning of my talk, eventually financing will be the central issue. At this point, the full interest charge must be taken into account, and a means of financing it must be found.

Other Issues

The IMF also offers fiscal advice on growth, prices, and distribution. In all its discussions with members, the IMF seeks faster growth, which is the principal way to ease the transition and the social burden of adjustment. While there is much to discuss about growth, 1 will mention one particular lesson the IMF has learned over many years: bureaucrats do not necessarily make superior industrial managers. On the whole, bureaucrats should not even be involved in industrial management or associated interventions, such as licensing for imports, new businesses, equipment, or access to foreign exchange. The IMF’s experience with licensing systems has on the whole not been a happy one, and I would argue that legislation allowing bureaucrats to involve themselves in these sorts of decisions should be severely circumscribed.

In terms of growth, there is also a “capital versus current” problem with some of the larger investment programs. Typically, donors will give capital but will not fund maintenance, which suffers as a result. In such a situation, the quality of an investment can decline over the years, because funding for maintenance comes out of current revenue and so is often the first item to be cut, since it is often more desirable to preserve transfers or wages and salaries. Thus, the IMF tends to emphasize the need to maintain capital equipment before undertaking massive new investments.

On prices, the IMF advises against direct controls in either the public or private sector. Such controls are distortionary, and the longer they operate, the more distortionary they become.

A quite controversial issue is the distribution of income and wealth. Until a few years ago, IMF staff generally viewed this question as a matter best left to national governments and thus did not often comment on it. This stance proved extremely useful, as it eliminated a contentious element from discussions with member countries. But in reality, adjustment and budget programs will inevitably affect the distribution of income and wealth, so that avoiding these subjects altogether is a rather cowardly way out. Increasingly, then, the staff have been talking with authorities about what should be done, for instance, to protect those most at risk from structural adjustment programs—those who will lose their jobs, require retraining, or suffer unduly from inflation. This subject is not always popular with country authorities, because the money to protect these people comes out of the budget at the expense of items to which the authorities may have assigned a higher priority. Establishing these kinds of priorities is very difficult and often involves subjective evaluations. But IMF staff now see it as their responsibility to at least raise these issues in discussing budgetary options.

Conclusion

Let me conclude with comments on four major weaknesses of IMF fiscal advice. First, as I have already noted, there may be too much emphasis on the size of adjustment and not enough on how the targets are reached. The focus needs to be on sustainable policies rather than on simply reducing the deficit by a certain percent. A targeted reduction should be sustainable over time. There is not much point in making adjustments that will be lost as soon as a program ends. I can cite many examples of programs that have stopped, only to be reactivated six months later after many hard-won gains have been lost.

Second, the amount of time adjustment requires is frequently underestimated. When I first came to the IMF, the amount of adjustment expected in most fiscal programs was 1–2 percent of GDP; today, it is as high as 6–7 percent. It may be possible to implement a 2 percent adjustment in a year-long program, but not a 6 percent adjustment. The political and social costs would be insupportable. So the focus may need to change from “quick and dirty” fixes to longer, more durable programs. Of course, the trouble is that more time means more money, and more money is what the IMF has not got, because it depends on a revolving capital base and a relatively short payback period.

The third element that needs to be looked at more carefully is the quality of IMF-supported measures. Negotiations are sometimes very intense, since they are conducted in two-week blocks that may stretch out to eight or ten weeks. Because the negotiations are concentrated into these limited periods, quality may be sacrificed in favor of measures that will simply provide revenue or cut budgetary expenditures. Quality needs to be given more thought.

Finally, the greatest strengths of IMF fiscal advice are also its greatest weaknesses: the emphasis on an accounting framework, the effort to put extrabudgetary items on the budget, and the focus on transparency. On the whole, these are valuable features of the IMF’s work. But it is also true that IMF staff are not elected officials, and perhaps they underestimate the difficulties elected officials face. It is unrealistic to argue that the IMF should be absolutely apolitical, but in the final analysis, political judgments should reflect the decisions of the IMF Executive Board and should not be made by the staff. It is inappropriate and misleading to argue that the staff should be more political. A politicized staff would undermine the IMF’s greatest asset—its objectivity.

Comment
Liam Ebrill

To begin, I would like to pick up on a few of the points made by Alan Tait, more to emphasize than to disagree with them. I will then use Poland’s experience over the last few years to illustrate some of these points and underscore the significance of certain issues raised in the discussion.

The fiscal deficit has traditionally been a focus—or at least it has been popularly perceived as a focus—of IMF programs. From an academic point of view, there is no perfect definition of the term “fiscal deficit.” Indeed, the deficit number that is finally used in analyzing an economic situation depends on the objective of the analysis. For example, a study concerned with the welfare of future generations would necessarily take into account whether pension plans are fully funded or not, offering one view of the appropriate fiscal deficit that should be used. However, the deficit Mr. Tait mentioned was the cash deficit, which is especially relevant to any discussion of the importance of the macroeconomic framework. Underlying this concern about the cash deficit is the monetary approach to the balance of payments, which has been described as a relatively crude view of the world. But in trying to gauge what is happening to an economy at large, the cash deficit is not a bad tool to use, particularly if capital markets are not well developed and a relatively direct link exists between some measure of the deficit and monetary developments.

In general, the IMF tends to be concerned with the fiscal deficit because of the organization’s focus on short-term macroeconomic stabilization. However, as Mr. Tait pointed out, there are also several kinds of cash deficits. And the reality is that focusing on any one definition is rather like squeezing a balloon: the pressure simply shows up somewhere else. For this reason, the IMF has numerous checks and balances in its programs. Rather than targeting just one quantity—the fiscal deficit—the programs also target variables such as net international reserves. The assumption is that if the deficit number is wrong for a given exchange rate, the pressure will show up in the reserve level. Putting checks and balances into the programs makes it possible to track an economy’s performance, at least to some degree. This approach is evidence of the usefulness of the simple macroeconomic framework in designing programming for various countries.

Experiences from Eastern Europe

A question was raised earlier about the IMF’s approach to the unemployment problem in Central and Eastern Europe. What staff have learned in looking at Poland and other countries in the region—and the unemployment problem is a good medium to explain this fact—is that the transition process is far more complex and will take much longer than was initially imagined. This issue also needs to be examined because of its profound influence on any estimates of the speed with which unemployment will go up. For example, should state enterprises hold on to some excess labor in the short term because social safety nets are not fully in place? The IMF’s reaction has been, in essence, to adopt a more flexible approach on the deficit itself. The deficit target must be an agreed-on balance between what can reasonably be financed and what the authorities need to spend to solve some of the problems that are causing trouble during the transition.

In other words, IMF-supported programming in Central Europe has been flexible in recognizing the differing circumstances of these countries. There is no point in asking for the impossible: it is better to find a transition path that will get the economy moving in the right direction, even if some imbalances have to be tolerated in the short term.

The case of Poland

Poland’s experience during the last three years helps to illustrate the points I have just made. Poland also provides some spectacular examples of the sorts of problems mentioned earlier.

Shock therapy began there at the beginning of 1990. I am sure that in the light of what he said earlier, Mr. Tait would view this approach as appalling, but the objective was to move the country’s fiscal position from a deficit of 7 percent of GDP to balance in one year. The result of this program was that Poland in fact had a significant surplus in 1990, because revenues were far greater than anticipated. One of the factors behind this performance was the outdated corporate tax system, which had never taken inflation into account. Because inflation was still relatively high in 1990, taxes on state enterprises rose enormously when inventories were revalued for tax purposes. The money found its way into the budget, resulting in a short-run revenue boom. It is important to remember that this windfall was solely the result of the interaction between a relatively high inflation level and the nominal tax base associated with inventory appreciation and depreciation allowances. The unfortunate aspect of the one-time capital levy was that it contributed to the decapitalization of state enterprises just as they were trying to adjust to the new market circumstances, sowing the seeds for some of the problems that subsequently emerged.

Mr. Tait mentioned the need to keep tax systems simple. He is certainly right. At the same time, some factors must be taken into account when a new tax system is set up, especially in a transition economy. One of the areas in which the difficulties of transition programs are most evident is the tax system. Setting up a new personal income tax system—such as the one that is now beginning to yield revenue in Poland—and a value-added tax system takes considerable time. These systems will eventually tax the emerging private sector and alleviate the burden on the state enterprise sector, but only eventually With hindsight, it is easy to see that Poland, which has made significant progress with its tax system but needs more time, is a case in point. Indeed, to this day there is still some debate about how to take proper account of inflation in the context of corporate taxation in Poland.

Since 1990, fiscal deficits have reemerged and are receiving much attention in the public debate on economic policy. These deficits reflect two phenomena. On the revenue side, Poland has had to continue to rely on the shrinking financial base of the state enterprise sector. The enterprise income tax yielded about 13½ percent of GDP in 1990, 5½ percent in 1991, and 4½ percent in 1992. This trend was probably to be expected, given the transformations under way among enterprises. Thus, on the revenue side, there has been a scramble to diversify the tax base as rapidly as possible. On the expenditure side, the troublesome phenomenon is the social safety net. The 7 percent of GDP that was spent in subsidies in 1989 was sharply curtailed at the outset of the 1990 program. Now, however, transfers under programs such as social insurance are rising. In approximate numbers, in 1990 these transfers amounted to some 3½ percent of GDP; in 1991, 5½ percent; and in 1992, around 8 percent.

There is therefore tremendous pressure on the expenditure side, and it must be faced. It is important to recognize that the Poles who are losing their jobs have been accustomed to lifelong job security, so that the current situation represents a very traumatic change for them. It is relatively easy for young people between the ages of 18 and 25 to adapt; shock therapy comes along, and all they see is new opportunities. But 45- and 50-year-olds who have worked for many years in state enterprises confront a far different and far more unpleasant reality, and the social safety nets, while not all that generous, are absolutely essential to these displaced workers.

The buzz phrase in the expenditure debate has become “improved targeting,” which in practice is difficult to implement. Some specific examples will illustrate just how difficult it is. For instance, a pension plan typically operates by providing retirees with an income based on the last 20–25 years of earnings. But in centrally planned economies like Poland’s before 1990, earnings’ histories for pensions simply did not exist. Thus, when Poland’s plan was first set up, everyone’s earnings’ history was one year long. With each year that history grows, of course, but what about those workers who are only a year or two from retirement? Under the new system, a built-in incentive exists for state enterprises to give huge salary increases to these people so that they will receive adequate pensions. That incentive will no doubt exist for several years.

Another example is unemployment insurance, which now exists in Poland. One major problem with the new system is the difficulty of verifying whether the people drawing unemployment insurance are actually unemployed. It is not clear that everybody receiving benefits is, because the new private sector—which is, relatively speaking, doing extremely well in Poland—is difficult to track. It is not even clear who is actually in the private sector, and it is possible that a significant number of people drawing unemployment benefits also have some sort of employment. Inevitably, such problems will exist, so that while efforts can be made to improve targeting, they will not succeed overnight. Accordingly, trying to move from where Poland is now to an economy with a sound fiscal system and sustainable growth is a little like walking a tightrope.

The sharp decline in output that occurred in Poland after shock therapy was initiated took many people by surprise. The popular perception was that if the centrally planned economies were as inefficient as everyone said they were, presumably that inefficiency would provide a “floor” to the level of output. All that could happen, the thinking went, was that output would increase the moment the centrally planned system was eliminated. Of course, this proposition proved false. The analogy to keep in mind here—one that has often been cited by others—involves the U.S. telecommunications system, which is dominated by AT&T. AT&T’s value added constitutes around ¼ of 1 percent of GDP. If the company were to disappear tomorrow, where would U.S. economic activity be a year from now? The decline would be not just ¼ of 1 percent of GDP, but much more. In other words, in Poland a complex communications system was in place, a network that was removed with one “big bang” and could not be replaced overnight. But the downturn in activity in Poland has leveled off. In fact, since early 1992 growth has been increasing, albeit sometimes hesitantly. On a year-on-year basis for 1992, Poland turned in positive GDP growth and was in fact the first Central European country to achieve this goal (other than the former East Germany, which is a somewhat singular example). I believe there is no reason why this growth should not continue in 1993.

The future

What does the future look like? The main point that should be emphasized is that Poland still has fiscal deficits. However, if the country can get through this transition period, then its prospects are actually very good. Poland is in that intermediate phase, on the tightrope, trying to balance demands to keep the deficit as low as possible in order to stem inflation with the need to continue deficit spending because of pressure on both the revenue and the expenditure sides.

Let me add a few brief words on state enterprises before I finish. State enterprises have been transforming in Poland at a higher rate than has been recognized. Too much has been made of the country’s mass privatization program, which has had a checkered history in recent Polish politics. In fact, individual privatizations have been occurring at a steady pace, and the latest numbers suggest that as much as 60 percent of total employment is now outside the true state sector. This estimate includes so-called commercialized enterprises that are not fully privatized but have, at least in principle, distanced themselves from the government and begun operating according to commercial principles. Poland’s state sector has shrunk to around the size of the state sectors in Scandinavian countries—quite an achievement in the short time that has elapsed since reform began.

Part of the explanation for Poland’s success is that agriculture was, by and large, in private hands before the reform process started, giving Poland a significant advantage over some of the other countries that are now starting down the same road. Nonetheless, the achievement is still remarkable. If the private sector continues growing at the rate of 10–11 percent, or even more, it will soon acquire the sort of weight that begins to count in the aggregate economy as a whole.

This is the situation that currently exists in Poland. The country has a relatively vibrant economy, but the fiscal accounts are still tied to the fate of the state enterprise sector. For this and other reasons, the economy remains under stress, with many of the features of a dual economy.

Summary of Discussion

Several participants stressed the point that the sustainability of a fiscal correction is more important than its size. Examples were given from Eastern Europe of countries that reduced their deficits substantially early in the transition, only to see these gains reversed by the side effects of subsequent structural reforms. Restructuring the banking systems—which requires vast funds—was cited as one structural reform that affects the budget. In Bulgaria, the fiscal costs of dealing with banks’ large, nonperforming loans provide a concrete example of this problem. There, a 4 percent deficit in 1991 grew to 5 percent in 1992 and is likely to reach 8 percent in 1993, in spite of substantial tightening in most other areas of the budget. Participants from the IMF agreed, however, that a too-rigid quantitative focus on the fiscal deficit can delay structural reforms, because policymakers will worry too much about possible budgetary effects. Domestic banking system losses were acknowledged to be the most spectacular example of this problem. It is important to eliminate them as soon as possible and to try to be explicit about what such losses mean for the budget.

There was some feeling among participants that even when a government’s fiscal target meets the short-term objectives of an IMF financial program, the IMF Executive Board may still argue for a smaller deficit. In a sense, countries are always under pressure from the IMF to reduce their deficit further, no matter how small it becomes. Participants wondered whether the IMF has an objective in making this demand that goes beyond short-term macroeconomic imperatives. In response, the idea was put forward that this pattern of behavior—if indeed it is a pattern—can be explained in part by the IMF’s position on the intergenerational transfers associated with sustained fiscal deficits. Some participants were uncomfortable with the possibility that these two objectives (short-term cash deficit correction and intergenerational transfers) might become confused in the discussion of actual IMF programs.

Another important topic was the problem of civil service retrenchment and, in particular, how to keep productive workers from leaving. Alan Tait argued that the only sound way to proceed was to adopt strong management policies, moving to a smaller, better-paid, and more highly motivated work force. Certainly it is not feasible to have a separation program and allow only the most productive workers to leave. Mr. Tait noted that the IMF itself adopted a tight managerial approach during a reorganization in the early 1980s but acknowledged that using such an approach could be more difficult in large, decentralized bureaucracies. Ultimately, the task of slimming down civil services must be linked to reducing the excessive amounts of legislation that civil servants are appointed to enforce. Every law passed creates more duties for civil servants; the solution to this problem is not just to cut staff but, if possible, to roll back the central functions of the civil service.

The discussion then shifted to possible methods of taxing some of the large gains in profits some enterprises are reaping as a result of structural reform (e.g., the huge profits in the Jamaican financial sector generated by interest rate reforms). Is it appropriate for some sectors to receive windfalls from the reform process when many others are being forced to make sacrifices? Mr. Tait warned against what he called a “knee-jerk reaction” to apparent bank profitability. Such reactions, which have been far too common in developing countries in the past, are at the root of much of the financial repression that later emerges in these economies. However, assuming that the profits in question are excessive and can be linked to some clear advantage, there are ways to deal with them. In the United Kingdom, for example, exceptional taxes have been levied to deal with such problems.

Participants agreed that providing incentives to encourage people to comply with new tax arrangements in dual economies is an important issue—for example, finding ways to persuade taxpayers to register with collection agencies. This problem was thought to be a particularly pressing one in the transition economies because of the need to find new and secure sources of tax revenue to replace traditional enterprise taxes. IMF speakers acknowledged the urgency of this problem but noted that too heavy-handed an approach to tax administration can destroy fledgling private businesses in these economies. A better way to approach the new small-scale private enterprises is to make good use of high tax thresholds. In general, the IMF favors such arrangements and is against the use of “tax police,” which some countries have seen as an effective tool in maximizing tax compliance.

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