Chapter

Introduction

Editor(s):
Mario Bléjer, and Ke-young Chu
Published Date:
June 1989
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Mario I. Blejer and Ke-young Chu

I. Overview

The implications of fiscal policy in developing countries have long been a focus of interest and discussion in macroeconomic analysis. The effects of fiscal policy and fiscal deficits on aggregate demand; on absorption, with the consequent impact on domestic inflation; on the level and composition of economic activity; and on the external balance have been at the core of stabilization programs. Studies have been made of fiscal policy’s role in promoting growth and in sustaining the development process by improving the quantity and quality of investment and savings. In this context, there has been growing concern that, when there were micro and macro disequilibria, stabilization programs alone would not induce satisfactory growth and development.

It has also become apparent that many countries, particularly in the developing world, face critical problems arising from the growing frequency and magnitude of external shocks. External shocks also have direct implications for the fiscal sector, particularly in countries with underdeveloped tax systems reliant on the taxation of international trade. The severity and unpredictability of external shocks, therefore, pose critical problems for formulating and executing fiscal policy in these countries, and there is increasing interest in devising analytical tools to formulate proper responses to external developments.

Fiscal policy instruments are also strongly interrelated with many other economic policy instruments. The lack of credibility of fiscal policy in some countries could trigger capital flight and a deterioration in the external balance. Such external policy instruments as exchange rates, tariffs, subsidies, and trade liberalization have fiscal impacts and important fiscal policy implications. Thus, these instruments should be used in coordination with fiscal policy and in a proper sequence.

Fiscal policy has always been a critical element of Fund-supported adjustment programs and, in this context, the issues described above have loomed large in the financial planning process. The theoretical and analytical interest in these issues, and their direct policy relevance have motivated Fund staff to undertake research on these topics, despite the considerable work on related topics already done in the Fund. A considerable number of studies on the specific aspects of fiscal policy in developing countries have been prepared recently in the Fund’s Fiscal Affairs Department, many of them in the Special Fiscal Studies Division. This volume consists of 13 such studies—some of which have been circulated largely for discussion within the Fund as working papers, while others have been published in professional journals or conference proceedings—placed within a coherent framework.

II. Fiscal Policy for Stabilization, Savings, and Growth

Part II consists of four papers focusing on the policy issues relating to the crucial role of fiscal policy in attaining and sustaining stability and growth. Stability and growth are phenomena that are both conflicting and complementary. Stability is a precondition for sustained growth; if a country wishes to attain and sustain macroeconomic stability, it should reduce excess aggregate demand throughout the economy. A lasting reduction in excess demand, in turn, can be facilitated and, in some cases, achieved only by means of a sustained growth in income. However, and in spite of these obvious truths, in many countries policies intended to promote growth often end up undermining stability. Fiscal policies are often used to induce a rapid expansion of aggregate demand, and, in many cases, they become a primary source of economic imbalance and instability.

A central issue in this area is how to enhance the complementary relationship between stabilization and growth. In “Fiscal Policy, Growth, and the Design of Stabilization Programs,” Vito Tanzi explores ways to improve stabilization programs in general and, more specifically, the Fund’s framework for stabilization programs by strengthening their supply-oriented structural core. For example, while a number of fiscal policy instruments can reduce a budget deficit in the short run, each instrument should be assessed on the basis of its ability to increase potential output and thus bring about a more durable fiscal adjustment. This strengthening would make the stabilization program more durable not only by facilitating the current fiscal adjustment but also by reducing the required future fiscal adjustment; that is, by properly combining stabilization with structural policies, an economy could grow out of its government debt. Tanzi suggests, therefore, that the Fund should support a relaxation of fiscal adjustment if a country is prepared to improve the quality of its stabilization program.

The low level of domestic savings is a critical bottleneck in the growth process in developing countries. Savings are low for a variety of reasons: the insufficient rates of return to capital and the absence of both well-functioning capital markets and institutions to compensate for the risks that are usually involved in saving and investment activities. This tends to dampen the propensity to save and invest. The traditional tax incentives designed to induce increases in domestic saving may not only be distortionary and place additional pressure on the budget but are also likely to be ineffective because of the low interest elasticity of saving in developing countries. In “Fiscal Policy and Mobilization of Savings for Growth,” Mario I. Blejer and Adrienne Cheasty discuss possible fiscal policy roles in promoting saving in such an environment. Based on theoretical and empirical studies showing the limitations of tax policy in this area, they suggest an alternative use of fiscal policy: to create a planned budgetary surplus and to arrange the efficient channeling of the surplus into investment.

In “Fiscal Rigidities, Public Debt, and Capital Flight,” Alain Ize and Guillermo Ortiz present a model in which fiscal rigidities and the lack of fiscal discipline are the sources of capital flight. In an unstable economic setting where the government is perceived to have weak fiscal discipline, a large fiscal imbalance without decisive policy action to reduce it gives rise to the public’s expectations that the imbalance will be financed through inflationary taxation. These expectations induce domestic bondholders to switch to foreign bonds. In such a setting, the government’s attempt to finance the external imbalance through foreign borrowing could encourage capital flight unless credible fiscal discipline is restored.

High inflation not only has critical allocative and distributional implications but is also detrimental to the growth process. Disinflation is costly, however, and finding an efficient disinflation process is a challenge for policymakers. In “High Inflation, ‘Heterodox’ Stabilization, and Fiscal Policy,” Mario I. Blejer and Adrienne Cheasty critically review the analytical aspects of the design of the recent heterodox stabilization programs in Israel and in three South American countries (Argentina, Bolivia, and Brazil). The positive side of these programs has been their apparent success in mobilizing public support for the implementation of drastic disinflation policies that have usually entailed significant costs during the period of adjustment. The paper concludes, however, that these policies would not have been able to provide long-run benefits without the use of fiscal policies to eliminate the sources of inflation, and that many elements—such as freezes, controls, and incomes policies—imply economic, political, and administrative costs and could damage the long-run growth potential of the economy.

III. Fiscal Policy and the World Environment

Many developing countries have been subjected to unusually large and unpredictable external shocks since the early 1970s. Aggregate economic activity and domestic prices in industrial countries became much more volatile in the 1970s than in the earlier decade, and the world prices of oil and non-oil commodities, the value of major currencies, and world interest rates also became highly unstable. After the abandonment of fixed exchange rates, the fluctuations in the values of key currencies made the effective exchange rates of developing countries much more unstable, depending on the major currencies to which their currencies were pegged. These external shocks had direct implications for the fiscal sector of many developing countries. They intensified the fluctuations (and thus magnified uncertainties) in government revenue and foreign grants, as well as in the availability of, and the conditions for, financing. External shocks also elicited diverse fiscal policy reactions, which had different degrees of success in neutralizing the impact of the shocks on the domestic economy. The papers in Part III focus on some of the fiscal policy implications of such external shocks and other exogenous developments.

In “Fiscal Policy Responses to Exogenous Shocks in Developing Countries,” Vito Tanzi analyzes the factors associated with recent external shocks, their impact on fiscal variables, and the policy responses in developing countries. He discusses the implications of three kinds of fiscal policy responses to rising revenue resulting from external factors: a decrease in debt, an increase in public investment, and an increase in current public expenditure. Tanzi also discusses the implications of alternative policy responses (a reduction of public spending and an increase in domestic borrowing) to declining revenue. While noting the limitations of various fiscal policy instruments in developing countries and the consequent inevitability of cuts in capital spending in the face of a negative external shock, Tanzi emphasizes that the adverse impact of the shock could be mitigated through improved efficiency.

The second paper adds a more empirical dimension to the analysis by studying the fiscal policy responses of a group of developing countries to external shocks. In “External Shocks and Fiscal Adjustment in Developing Countries: Recent Experiences,” Ke-young Chu presents an overview of fiscal developments in 18 developing countries from 1962 to 1982. He focuses on how aggregate government expenditure responded to both the anticipated and unanticipated components of external shocks. Chu’s analysis suggests that an unexpected downturn in revenue and the lags in formulating and executing effective fiscal policy responses pose serious problems for developing countries. The study stresses the importance of a longer-term view in formulating and executing fiscal stabilization programs.

The last paper brings the analysis closer to an important source of external shocks for developing countries: economic fluctuation in industrial countries. Industrial countries are the dominant force in international capital transactions and in international trade in both manufactures and primary commodities. World trade prices and volumes, as well as lending conditions, are determined in important respects by the economic conditions in industrial countries, including their policy mixes. In “Transmission of Effects of the Fiscal Deficit in Industrial Countries to the Fiscal Deficit of Developing Countries,” Ahsan H. Mansur and David J. Robinson analyze the channels through which fiscal shocks are transmitted from the industrial to the developing countries. One important channel consists of the impact of the fiscal and monetary policy mix in industrial countries on world interest rates, and the latter’s impact on the debt-service burden, import capacity, growth, and fiscal balances in developing countries. Mansur and Robinson draw a number of policy implications for both groups of countries.

IV. Interaction of Policies

The role of fiscal policy cannot be discussed meaningfully in isolation. The linkages between fiscal, monetary, and external sector policies are an important element of the analysis. The number of examples is indeed large. Bank financing of government deficits is a significant source of inflation in many countries. This channel for government financing provides a direct linkage between fiscal and monetary policies. The government’s budgetary operations also affect the external balance through their impact on aggregate demand, on domestic savings and investment balance, and on individual taxes and subsidies. All four papers in Part IV deal with some of these linkages.

In “Fiscal Expansion and External Current Account Imbalances,” Gloria Bartoli builds an empirical model which explains the external current account balances of a number of developing countries on the basis of their domestic savings-investment gap. The model focuses on the fiscal sector’s contribution to this gap. The results suggest that not only the changes in the fiscal balance but also how these changes are achieved have important implications for the external balance.

In “Lags in Tax Collection and the Case for Inflationary Finance: Theory with Simulations,” Vito Tanzi examines methods of financing budget deficits in developing countries by expanding the conventional analysis of inflationary financing to analyze its impact on the tax system. In analyzing how inflation could affect real tax revenue, Tanzi focuses on the role of four critical parameters: (1) the price elasticity of the tax system, (2) the ratio of tax revenue to national income, (3) the ratio of the money supply to national income, and (4) the elasticity of the demand for real balances with respect to national income. The analysis suggests that based on realistic assumptions using these parameters, the existence of lags in tax collection implies that the government’s gains from inflationary financing are likely to be lower than is commmonly assumed.

In “Government Spending, the Real Interest Rate, and Liquidity-Constrained Consumers’ Behavior in Developing Countries,” Nicola Rossi develops a dynamic optimization model to test empirically the interest rate’s impact on savings in developing countries where consumers face binding liquidity constraints. The results suggest the dominance of the liquidity constraints, relative to interest rates, in the determination of savings. Rossi argues that the dominance of the liquidity constraints, which is more pronounced in low-income countries than in other developing countries, may help to explain the low interest elasticity of savings in the former group. The results indicate that while domestic saving is responsive to the real interest rate, large changes in the rate of interest would be required to induce significant increases in domestic saving.

The final paper in Part IV deals with the conflict between, and complementarity of, fiscal and external policy instruments. In “Fiscal Dimensions of Trade Policy,” Ziba Farhadian-Lorie and Menachem Katz review the literature and focus on two important aspects of this policy interaction. The first aspect is the efficiency of trade taxation. Although the presence of the cost of tax collection and other tax policy objectives (such as revenue, protection, and market failure) dilutes the strength of the conclusion, the authors argue that the share of trade taxes in the optimal tax basket is still lower than the actual shares in many developing countries (as shown in the empirical section of the paper). The second aspect is the static and dynamic role of fiscal policy in the external adjustment; here, Farhadian-Lorie and Katz focus on the impact of fiscal policy instruments on the external balance under fixed and flexible exchange regimes.

V. Fiscal Policy Issues in Selected Countries

Part V, the final part of this volume, consists of two studies dealing with recent fiscal policy experiences in the Philippines and Israel, respectively. These studies shed light on some of the issues dealt with earlier in the volume in the context of actual experiences in specific countries.

In “Effects of the Budget Deficit on the Current Account Balance: The Case of the Philippines,” Ahsan H. Mansur estimates the budgetary impact on the external balance of the economy by building a small econometric model. In this model, the budget affects import demand through both the impact of expenditure on domestic absorption and the impact of bank financing of the deficit, through its impact on the money supply and domestic prices. The budget, in turn, is affected by imports through their impact on tariffs, a major component of tax revenue. Mansur concludes that the budgetary impact on the external balance was significant for the Philippines.

In “The Inflationary Process in Israel, Fiscal Policy, and the Economic Stabilization Plan of July 1985,” Eliahu S. Kreis analyzes Israel’s recent stabilization program. From 1973 through the mid-1980s, Israel experienced extremely high and volatile inflation which originated largely in the country’s fiscal imbalance. Unlike earlier programs, which had addressed either inflation or the external imbalance, the July 1985 program focused on improving, concurrently, both price stability and the external balance. Kreis concludes that the program has been successful in achieving these objectives without incurring significant real costs.

VI. Concluding Remarks

The papers in this volume analyze the roles of fiscal policy in promoting and sustaining stabilization and growth in developing countries. In examining these crucial roles, the papers stress the importance of considering, in the analysis, the close interdependence between fiscal, monetary, and external sector policies.

The experiences of the 1970s and the 1980s have highlighted the fact that stabilization and adjustment are, indeed, necessary conditions for growth. At the same time, these experiences have indicated that efficient structural measures are of crucial importance in mobilizing domestic and foreign savings to attain a sustained rate of growth. The 1970s and 80s have also provided additional evidence regarding the implications of the volatile external environment for the fiscal sector in developing countries, as well as the impact of fiscal policy on the external sector.

The papers in this volume have certainly not exhausted the stock of fiscal policy issues that deserve researchers’ attention. Among the issues that need to be investigated further, an important one relates to the budgetary implications of structural measures, both in the fiscal and nonfiscal areas. For example, it would be useful to study the short-run and long-run impacts on the fiscal balance of structural reforms in goods, labor, money, and capital markets, as well as the impact of trade liberalization. Other issues include the effects of uncertainty on the performance of the fiscal sector and on fiscal discipline. For example, it would be useful to study how the level of public expenditure is planned in the face of uncertainty about the magnitude of public revenue and how these plans are subsequently revised. It would also be of great interest to study how the fiscal authorities in developing countries reach a political consensus on the fiscal policy stance. The roles of both public enterprises and public financial institutions are also very important topics. An additional issue, which has implications for the design and implementation of specific fiscal adjustment policies, concerns the methodology used to measure and assess the impact of a country’s fiscal stance; although a number of studies have been done on this topic,1 it remains underresearched.

See, for example, the studies in a recent Fund publication, The Measurement of Fiscal Impact: Methodological Issues, IMF Occasional Papers, No. 59 (Washington: International Monetary Fund, 1988).

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