3 Fiscal Policy, 1972–82, An Overview

International Monetary Fund
Published Date:
March 1986
  • ShareShare
Show Summary Details

This chapter contains a broad account of the pursuit of fiscal policy over a decade that witnessed the largest economic imbalances experienced on a global basis in the postwar period. While the sheer magnitude of the external shocks emanating from the two oil crises and the ensuing world recession had a broadly similar impact on the smaller industrial countries, differences in individual circumstances caused deviations from the more general policy reactions. As this part of the study emphasizes the general aspects of fiscal policy, events peculiar to individual countries are given very limited coverage. Therefore, certain policy actions, although significant in a narrower context, may be neglected in this chapter. Some of these are contained in Part II, which deals with individual countries in some detail.

Economic Setting and Fiscal Stance in the Early 1970s

The first two years of the period under review witnessed a continuation of the strong growth performance that most countries in the group had achieved during the 1960s. Expansion of economic activity in the latter half of 1972 and the first half of 1973, in particular, was accompanied by a marked acceleration of inflation rates that had been on the rise in most industrial countries since the mid-1960s. Concern over the inflation problem induced governments in a number of countries to tighten financial restraint policies. Partly as a result of the stricter stance of fiscal and monetary policies, signs of a slowdown of output expansion began surfacing even before the abrupt oil price increases late in 1973. Although levels of unemployment differed substantially among the countries—Ireland suffered the highest rate of about 6 percent—the employment situation was not a problem, and most countries in the group actually experienced a fall in the unemployment rate in 1973. Similarly, in these years the current external balances were not a matter of great concern generally, although there were exceptions, such as Denmark, which experienced persistent balance of payments problems. In fact, 7 of the 13 countries had current account surpluses in both 1972 and 1973; that is, Australia, Belgium, Luxembourg, the Netherlands, New Zealand, Spain, and Sweden.

As indicated, inflation was a growing problem in the early years of the period, even before the first oil price explosion. All countries in the group experienced accelerated price increases in 1973, and in some countries inflation was regarded as the dominant economic policy problem. The rates of inflation differed markedly among the countries, however, with Iceland experiencing the highest rates (10 percent in 1972 and 20 percent in 1973), and Luxembourg the lowest (5 percent in 1972 and 6 percent in 1973). The policy response on the fiscal front in most countries was to tighten the stance, usually as part of a more general approach to overall demand management. About half the countries in the group succeeded in improving their fiscal positions from 1972 to 1973 (Table 2.11 and Chart 4), and in a few additional countries, the balance remained approximately constant. Only in four countries—Australia, Austria, Iceland, and Ireland—was there a marked increase in the fiscal deficit in 1973. In Australia, the increase was the result of a conscious policy of fiscal expansion, in Austria and Ireland, a higher priority was assigned to stimulating activity through increased public spending; and in Iceland, incomes policy-oriented tax and expenditure measures led to fiscal deterioration.

Although most countries in the group incurred fiscal deficits in 1972 and 1973 (Table 2.11), except Denmark, Finland, and Luxembourg, which realized surpluses in both years, the size of the deficits was generally small compared with subsequent developments, and deficit financing did not pose problems at this time. External financing was nonexistent in most countries, the only exceptions being Iceland and Ireland, which financed part of their public investment by foreign borrowing. Similarly, domestic monetary financing was in most instances not resorted to in any significant measure. On the contrary, a number of countries pursued active open market operations in support of monetary policy. Thus, in 1972 and 1973, in Australia, Belgium, the Netherlands, and Spain, more was borrowed from the nonbank private sector than was needed to finance the deficit, in order to reduce liquidity in the economy, much of which stemmed from capital inflows. The proceeds were used to reduce external debt or to repay short-term domestic debt.

Fiscal policy achieved a fair amount of success in the early 1970s; moreover, improvements in fiscal positions contributed to the anti-inflationary efforts of general demand management. There are several explanations, both economic and political, for this success. An important one may be the relatively flexible fiscal systems that made possible the pursuit of flexible policies in these years. In the early 1970s, expenditure levels and tax burdens were substantially lower than they are now; automaticity in significant expenditure categories was much less pronounced, as were inflation-adjustment mechanisms on the revenue side. Public finances were generally more balanced than they later became, and interest payments did not constitute an overly heavy claim on budgetary resources in most instances. Moreover, tax reforms had been recently, or were being, undertaken at the beginning of the period in a number of countries; notably, the introduction of value-added taxes in countries connected with the EC. It was a widely held view at this time that these tax reforms would substantially improve the fiscal armory for both allocation and stabilization purposes.

Not all measures taken around this time were conducive to flexibility in fiscal policy, however. Foundations previously laid for generous social entitlement programs were being strengthened, and in a number of countries social security expenditure had been increasing rapidly since the 1960s. This development would prove a major element in the subsequent difficulties policymakers encountered in their attempts to control public expenditure growth.

Policy Response to First Oil Crisis

The abrupt increase in energy prices late in 1973 and in 1974, as well as the ensuing world recession, affected the smaller industrial countries profoundly: their economies were generally highly open and susceptible to external impulses, and most of them were not endowed with rich domestic energy sources. In a number of these countries, fiscal policy was the major instrument of economic stabilization, and the policy response was generally to shift the fiscal stance in a highly expansionary direction. This policy was broadly viewed as a proper reaction to the recession, which was believed to be short lived. Growth, it was argued, would soon pick up globally and a more normal stance of policy could then be resumed.

The strength of the policy reaction to the recession naturally differed among individual countries, depending on their perception of the economic threat and domestic policies already in place. As indicated above, output expansion had started to slow down in some countries before the oil price explosion; for this reason, several of them had already introduced expansionary fiscal policies to counteract emerging slack in labor market conditions. Among these were energy-rich countries such as Australia, the Netherlands, and Norway, which might be expected to have been less severely affected by the oil crisis than other countries in the group. Similarly, domestic policies in Australia and, to a lesser extent, in Spain—the two countries in the group with the smallest foreign trade sectors—were actively directed at an expansion of social benefits and, in Australia, at a general expansion of public sector absorption of resources in line with the Government’s policy at the time. A policy aimed at enlarging the role of the public sector in the economy was also being pursued in Luxembourg during 1974–75.

When the recession deepened and it became clear after the mid-1970s that the adverse impact of the oil crisis would extend to output and employment as well as to prices, the expansionary stance of fiscal policy was strengthened in almost all countries in the group. With the sharp deterioration in employment in 1975, the highest priority was shifted from controlling inflation, which had been considered the main problem in the preceding years, to maintaining employment. Although the type of expansionary measures differed in individual countries, they frequently included both expenditure increases and tax reductions and entailed a very sharp deterioration in the fiscal positions of all the countries except Sweden, which managed to contain its deficit until 1978.

A typical expenditure measure in these years was increased employment-oriented outlays, such as public investment, in some cases, through increased advances to states and local governments and subsidies to enterprises. Some countries, including Denmark, Luxembourg, the Netherlands, and Sweden, introduced special employment policies that were implemented through schemes either to increase public employment or to compensate private sector enterprises for increasing or maintaining the number of their employees. Also, a special boost was given to the objective of maintaining living standards through improvements in social benefits. Countries that pursued this policy with special vigor were Australia, Belgium, the Netherlands, Spain, and most of the Nordic countries. Examples of more specific measures in 1974 and 1975 include activation of contingency budgets and release of frozen funds of local governments in Austria; relaxation of ceilings on local government investment and subsidization of interest costs on loans for residential construction in Denmark; and the setting up of special credit facilities for enterprises in the Netherlands.

In addition to expenditure measures, a number of countries implemented tax reductions to stimulate the economy. These often took the form of reductions in personal income tax rates or tax incentives for private sector investment, such as rate reductions and, more often, special depreciation allowances. In Austria, the Netherlands, and Denmark, the high tax burden motivated a reduction in income taxes. In Denmark especially, considerable political opposition in 1975 over the high marginal rates of the income tax led to a substantial reduction in personal income tax. Also in Denmark, revenue measures to stimulate demand included a large reduction in 1975 in the value-added tax; similarly in Ireland, items were exempted from the value-added tax. Several countries introduced special tax incentives, originally on a temporary basis, to encourage transfer of resources to the export sector. The fiscal measures thus usually aimed at the stimulation of both investment and private consumption. Norway is the one notable exception. As investment levels were already high in Norway, the authorities decided instead to stimulate private consumption, with improvements in social security benefits and income tax reductions playing a significant role.

Shift in Fiscal Stance After MID-1970S and Changes in Policy Approach

Shortly after the mid-1970s it was becoming widely recognized that the strength and duration of the recession had been underestimated. While economic activity had picked up in most countries in the group in 1976 and the unemployment situation had stabilized in a few countries, these did not prove to be lasting improvements. Although two years of highly expansionary fiscal policies had contributed to the temporary improvement, it was nonetheless clear that these policies had at the same time fueled accelerating rates of inflation and widening current external deficits. These developments were of grave concern to governments in the smaller industrial countries; they generally responded by endeavoring to redirect the stance of fiscal policy in a restrictive direction.

The economic imbalances, which in a number of countries had reached unprecedented proportions in the postwar period and were assuming an increasingly structural character, brought about a shift in policy approaches in many countries. There was growing recognition that the imbalances could not be eliminated in the short term, and a few countries, including Finland, Ireland, and Spain, adopted medium-term overall economic policies to address the problem. To reinforce their political resolution to restore fiscal balance, a growing number of countries publicly announced specific medium-term fiscal targets for the containment or reduction of fiscal deficits, tax burdens, or public expenditure/GDP ratios, or all of these. Another, and perhaps more fundamental, change in approach emanated from a growing doubt as to the appropriateness of traditional demand management policies in dealing with economic imbalances of this magnitude. Such policies were seen as liable to cause still higher rates of unemployment. Views of this kind were expressed at different times, for example, in Australia, Ireland, the Netherlands, and New Zealand. Preference was expressed for measures that would be directed at the cost side by attacking the wage-price spiral or measures that directed resources into the export sector. Of course, certain countries in the group already had long experience with measures of this kind, notably incomes policy measures, but selective measures tended to assume an enhanced role in the following years.

While there was growing awareness of the need to improve fiscal positions, most governments nonetheless remained committed to the objective of stimulating employment and economic activity and to preserving living standards. This set of objectives posed an acute dilemma for fiscal policy and frequently led to inconsistencies in the pursuit of policy, as discussed in the following section. A number of countries addressed the problem by adopting strategies that sought to maintain a restrictive overall stance of fiscal policy while at the same time introducing selective measures of stimulus that would not impart undue pressure on prices and the current external position. This approach was perhaps most clearly spelled out in the so-called dual strategy followed in Austria.

The results of these changes in approach were mixed, however, as fiscal deficits did not generally decline in subsequent years, although in many instances they tended to stabilize. But with a few exceptions, levels of expenditure continued to rise in relation to GDP, as did tax burdens. The commitment of governments to cushioning the adverse impact of the recession on the economy and living standards meant the maintenance and, in several cases, intensification of measures from the preceding period of fiscal expansion and even the introduction of new ones.

The selective measures taken at this time and in subsequent years included various public investment programs, special employment promoting schemes, personal income tax reductions, and selective tax incentives for investment, including tax credit for special types of investment. Social benefits remained in many countries the underlying force of expenditure growth because of demographic factors, rate increases, extension of coverage, and the automatic effects of the depressed state of economic activity on unemployment compensations. Indexation mechanisms relating to personal income taxation as well as significant expenditure categories proliferated over the period. In some countries, fiscal measures to support incomes policies were pursued vigorously, commonly entailing both increased spending and revenue loss. As the decade progressed and structural problems became more pronounced, selective measures increasingly took the form of industrial support, including transfer of resources to the export sector, interest cost subsidies, assumption of loan obligations, and the granting of loan guarantees.

To counteract an undue expansionary impact of these selective measures, a common response was to increase indirect taxes, such as the value-added tax and, in some cases, taxes on energy use. Indirect tax increases were especially pronounced in Austria, Denmark, Iceland, Ireland, and the Netherlands. Also, in certain countries, including Austria, Belgium, the Netherlands, and especially Spain and Sweden, social security contributions rose rapidly, sometimes with adverse repercussions on business activity and employment. Australia, the Netherlands, and Norway benefited from a large increase in revenue from oil and natural gas in the later years of the period. However, the protracted recessionary conditions generally retarded revenue growth. Most countries tried to contain overall expenditure growth from 1976 onward, but with little success.

Although some countries were initially able to improve their fiscal positions, it soon became clear that notwithstanding public policy announcements of fiscal restraint, several obstacles blocked restoration of fiscal balance; the record shows that for the rest of the period, most countries had severe fiscal difficulties.

Policy Response to Second Oil Crisis

The second oil price explosion in 1979 contributed to a renewed slowdown in economic activity, an upsurge in prices, and widening current external deficits. These events proved to be a major obstacle to fiscal improvement. Mindful of the disappointing experience with expansionary fiscal policies in the wake of the first oil crisis, governments generally reacted cautiously, and initially the battle against inflation was assigned priority. In contrast to the policy stance during 1974–75, fiscal policy remained tight for a time, as far as discretionary action was concerned. Apart from the need for fiscal adjustment, which had grown continuously in preceding years, the tight fiscal stance was required to support the efforts to prevent the impact of the oil price increase from causing a domestic wage-price spiral.

As already mentioned, the practice of stating policy objectives in quantitative terms had become more common, and by this time more than half the countries in the group had announced specific fiscal targets for restoring balance over a specified period. The second oil crisis upset basic assumptions underlying such plans, with the result that countries found it necessary to phase reduction of the deficit over a longer period of time. Improvements in external conditions also tended to be viewed as a prerequisite for fiscal adjustment, while additional factors further contributed to the slippages in the tight fiscal stance that soon emerged in a number of countries. Thus, as a result of deteriorating employment, some governments intensified employment-supporting measures, including wage-cost subsidies. In other instances, social security expenditure and support to industries facing difficult structural adjustment problems were increased. In addition to slippages in the policy stance, fiscal adjustment after the second oil crisis was further complicated by the responses of the automatic stabilizers to the recessionary conditions and by a markedly reduced scope for fiscal action on account of growing rigidities in fiscal systems. These issues are considered in the following chapter.

Fiscal Policy and Prospects in the Early 1980s

The plans for fiscal adjustment that have been announced in many of the smaller industrial countries and expressed as specific mediumterm fiscal targets are in some cases supplemented with programs in specific areas. Some of these programs have already been formulated with a considerable degree of precision and are even in varying stages of implementation; others are still under consideration. In still other instances, there is general awareness of an urgent need to undertake a fundamental restructuring of the public finances, but political controversies have hampered progress. This section concludes with a brief look at some of these programs.

In Austria, Belgium, and Spain reforms or reviews of the social security system are being undertaken. In Austria a contemplated review would pay particular attention to the pension system. In Belgium, where the financial position of the social security system has deteriorated rapidly, measures have been taken to limit the increase in benefits, and a comprehensive review is being worked out that would improve efficiency with respect to income redistribution and work effort. Also under consideration is a new means of financing the system that would cease to distort the cost of labor relative to other domestic factor costs. In Spain, although the economic program aimed at improving the social security system was initiated in 1977, progress has been slow. Renewed efforts are being made, however, to reduce anomalies in the present system, with special emphasis on its negative impact on labor costs. In Denmark and Iceland measures have been taken to reduce automaticity in expenditure decisions by suspending indexation mechanisms. How permanent this arrangement will be, however, remains to be seen. And, on the expenditure side, although not intended as a fiscal adjustment, Luxembourg’s substantial new and temporary budgetary outlays to restructure the steel industry were largely financed by increased taxation, probably of a more permanent nature; and in Sweden there has been a growing tendency in recent years to make industrial support conditional upon restructuring.

Programs relating to the revenue side are more equity and efficiency oriented, although revenue-raising objectives are also involved. In New Zealand a tax reform was initiated in 1982, with the aim of reducing progressivity in the income tax to reduce its adverse impact on work effort and initiative, tax compliance, and resource allocation. Extension of the sales tax or the introduction of a value-added tax is under consideration. In Norway progression of personal income taxes at the lower income levels and heavier taxation of higher incomes is being considered, as well as an enlarged share of indirect taxes. And in Sweden, where marginal income tax rates are among the highest in industrial countries, the adverse impact on work incentives, in particular, induced the authorities to prepare a reform of the personal income tax system for implementation in 1985; under the reform, the marginal rates would be reduced substantially and the revenue loss met, inter alia, by a reduction in the indexation of tax brackets and a ceiling on interest deductibility. Finally, several countries have in recent years implemented a series of reductions of social security contributions to lessen the cost of labor.

    Other Resources Citing This Publication