Chapter

6 External Shocks and Fiscal Adjustment in Developing Countries: Recent Experiences

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

I. Introduction

In many developing countries, a major feature of the fiscal sector is the importance of government revenue deriving directly or indirectly from external trade. This results from both the dominance of trade in their economies and their weak administrative capability, which makes them rely heavily on the taxation of external trade because it can be easily administered.1

Therefore, in highly open developing countries, the fluctuations in external trade can be transmitted directly to the fiscal sector. The large fluctuations in trade and the uncertainty surrounding them pose serious problems for the formulation and execution of fiscal policy.

The international economic environment for developing countries has changed substantially since the early 1970s. The cyclical fluctuations of industrial economies have become more pronounced than they were in the 1960s, and the prices of internationally traded goods-particularly primary commodities-have become more volatile. Against this background, the overall fiscal deficits of developing countries, on average, were higher, and fluctuated more sharply, during 1972-82 than during 1962-71.

The fiscal and external sectors could interact through a number of channels. A greater fluctuation in the target for government expenditure could result in a greater fluctuation in actual expenditure. A greater fluctuation in the target for government expenditure could originate in a greater fluctuation in external trade if the targets were based on anticipated revenue, which, in turn, would depend on anticipated future trade.

Increased fluctuation in the fiscal balance may be a direct consequence of increased fluctuation in external trade, an important revenue base. Another important source of fiscal instability is fluctuation in the availability of foreign financing, which also is related to world economic conditions. Furthermore, errors in anticipation, other constraints on policy instruments, lags, and possible asymmetry of government responses could not only aggravate fiscal instability but also contribute to both the greater persistence, and the worsening, of fiscal imbalances.

This paper analyzes fiscal developments in a group of 18 developing countries during 1962-82 and examines empirically several aspects of fiscal adjustment processes. It asks such questions as the following: How did fiscal balances behave during different phases of recent world trade cycles? How did revenue and expenditure contribute to fluctuations in the deficit during these cycles? Were increases in fiscal deficits and the consequent fiscal crises following the two recent world recessions attributable to a reduction in revenue or to an expansion of expenditure? Given the institutional dependence of revenue on external developments, how did government expenditure behave during the trade and fiscal cycles? How did expenditure respond to anticipated and unanticipated external shocks? How did fiscal discipline affect the long-run performance of individual countries in the group? Was the long-run deterioration in the fiscal balance related in any way to the amplitude of the fluctuation of the fiscal balance-that is, was the long-run fiscal deterioration partly a consequence of the fiscal fluctuation? What were the policy implications of the greater fiscal fluctuation?

The organization of this paper is as follows. Section II describes fiscal developments in the 18 sample developing countries during 1962-82. Section III analyzes sources of fiscal fluctuation in the sample countries, with particular emphasis placed on the relationship between trade cycles and fiscal cycles. Section IV analyzes fiscal policy responses to external shocks and the consequent fiscal imbalances. Section V draws conclusions from this analysis.

II. Overview of Fiscal Developments in Eighteen Developing Countries

The 18 sample countries are the developing countries for which consistent fiscal and external trade data are readily available from 1962 through 1982. During this period, world trade fluctuated markedly, particularly around the times of the two world recessions in 1975 and 1981-82. The sample consists of 4 countries in Africa, 7 in Asia, 1 in the Middle East, and 6 in the Western Hemisphere. (See Table 1.) Most are highly open, non-oil primary commodity exporters that rely heavily on the taxation of international transactions for their central government revenues.2 In 1980, such taxation accounted, on average, for 20 percent of total government revenue and 25 percent of tax revenue; for several countries, it accounted for more than 30 percent of total government revenue, suggesting the importance of the external sector as a source of government revenue. (See Table 2.) The importance of the external sector is much greater than is suggested by these statistics, because these countries also rely indirectly on the external sector for revenue—particularly on revenue from the taxation of incomes or transactions deriving from international transactions.3

Table 1.Eighteen Developing Countries: Location, Openness, and Major Exports, 19801
OpennessMajor Exports2
LocationShare of trade

value in GDP
TotalPrimary

commodities
ServicesManufactures
percentnumber of countries
All sample countries75.1181242
Africa60.64400
Asia96.57322
Middle East90.61010
Western Hemisphere57.26510
Table 2.Eighteen Developing Countries: Importance of Taxation on International Transactions, 19801
Average Share of Tax Revenue from

International Transactions in:
Total revenueTotal tax revenue
percent2
All sample countries19.925.2
number of countries
All sample countries1818
Shares (in percent)
40 or more13
30-4044
20-3044
10-2031
0-1066

1. Long-Term Trend

One of the notable changes seen in the fiscal balances of the sample countries over the years is the deterioration in overall deficits. Deficits, on average, more than doubled, increasing from 2.8 percent of gross domestic product (GDP) during 1962-71 to 5.9 percent of GDP during 1972-82. (See Table 3, Part A.) This increase in deficits resulted entirely from sharp increases in expenditures as a percentage of GDP, as they, on average, exceeded increases in revenues.4

Table 3.Eighteen Developing Countries: Developments in Fiscal Balances and External Trade, 1962-821(Percentage of GDP)
1962-711972-82
A. Average Over Time2
Fiscal balance
Deficit2.85.9
Foreign financing of deficit1.41.6
Revenue316.018.9
Expenditure18.824.8
External trade
Total trade53.663.5
Exports23.926.5
Imports29.737.0
Trade balance deficit5.810.5
Current account deficit2.65.5
B. Fluctuation Over Time2,4
Fiscal balance
Deficit1.42.5
Foreign financing of deficit0.71.2
Revenue1.31.8
Expenditure1.83.0
External trade5
Total trade3.96.8
Exports1.73.5
Imports2.84.7

Between the two periods, the external balances of the sample countries also deteriorated sharply as a result of increases in imports. The average trade balance deficit almost doubled, from 5.8 percent to 10.5 percent of GDP; the average current account deficit also deteriorated.

2. Fluctuation

The deterioration in fiscal balances of the 18 developing countries between 1962-71 and 1972-82 was accompanied by increased fluctuation of fiscal balances around their trends. The indices of fluctuation of overall deficits almost doubled, on average, from 1.4 to 2.5; similar indices for both revenues and expenditures also increased between the two periods. (See Table 3, Part B.) This increased fluctuation of fiscal balances was accompanied by similarly increased fluctuations in revenue, foreign financing, and external trade. The indices of fluctuation in trade values increased, on average, from 3.9 to 6.8 as a result of greater instability of both exports and imports.

The large fluctuation in fiscal balances of the sample countries was particularly notable during the two recent world trade cycles of 1971-76 and 1977-82. (See Section III for details.)

The increases in the fluctuations of fiscal balances and trade values did not exceed the increases in their averages. Similarly, there is no evidence that the dispersions of the fluctuations become more pronounced if they are normalized by their averages.

This overview suggests that the increase in the fluctuation of fiscal balances was restrained, in the sense that it did not exceed the increase in deficits. This proportionality itself raises a serious question, however, about the proper relationship between deficits and their fluctuation, because a simple extrapolation of this proportionality implies that the fiscal balance should not fluctuate when fiscal equilibrium is maintained over a number of years. This implication is obviously unrealistic, because it should not be unusual for the fiscal balance to fluctuate even if the balance averages zero over a period of years. It is, therefore, realistic to expect the increase in the fluctuation of fiscal deficits to be less than proportional to the increase in their levels. From this perspective, the increasing fluctuation in fiscal deficits and the cyclical appearance of fiscal crises are disturbing.

III. External Shocks, Fiscal Policy Responses, and Fiscal Fluctuations

1. Sources of Fluctuation in Deficits

In Section II, it was shown that for the 18 sample countries, expenditures fluctuated more than revenues during the sample period. This result suggests that the fluctuation in expenditures, rather than that in revenues, was the immediate cause of the unstable deficits. To test this hypothesis, the fluctuation of the deficit is regressed on the fluctuations of revenue and expenditure, all as percentages of GDP, separately for each sample country as follows:

where edit, erit, and egit denote deviations of the deficit (dit), revenue (rit), and expenditure (git) as percentages of GDP for country i from their respective trends, which are derived by regressing dit, rit, and git on the time trend. The estimated equations (1) and (2) would indicate not only whether revenue or expenditure was a dominant factor underlying the fluctuation of the deficit but also the extent of the correlation between the fluctuations of revenue and those of expenditure. The relative dominance of revenue would yield a higher coefficient of determination for equation (1) than for equation (2); a positive correlation between revenue and expenditure fluctuations would yield estimates αˆri and αˆgi smaller than 1.5

The estimation results are summarized in Table 4. The results suggest expenditure fluctuations as the dominant cause of the instability in the fiscal balances. The adjusted coefficients of determination average 0.13 for equation (1) and 0.60 for equation (2). The estimates of the coefficients α.i are statistically significant in only 7 out of the 18 cases for equation (1), but 17 cases out of 18 for equation (2), at the 5 percent level. The results also suggest a strong positive correlation between the fluctuations of revenue and those of expenditure; the coefficients αˆ.i average larger for expenditure (0.65) than for revenue (0.05), but are substantially less than 1 in both equations (1) and (2). The correlations between deficits and revenues are estimated to be weak.

Table 4.Eighteen Developing Countries: Relative Importance of Fluctuation of Revenue and Expenditure in Fluctuation of Deficits, 1962-82
Regression of Deficiton1
RevenueExpenditure
Average statistics2
Adjusted R0.130.60
Coefficient (αˆ.1)0.050.65
Statistical significance of coefficient (αˆ.1)number of countries
Significant at:
1 percent414
5 percent717
10 percent717
20 percent1017
Not significant at
20 percent81

These results, however, do not necessarily refute the importance of the external circumstances as an ultimate cause of fiscal instability. Whereas the fluctuations of expenditures may have originated in unstable fiscal targets not necessarily related to the external circumstances, it is not inconceivable that external circumstances were responsible for the fluctuations in expenditure, either by affecting the target expenditure or by affecting the part of expenditure that was an instrument for fiscal adjustment. Moreover, in many countries, a substantial part of government capital outlays is directly linked to foreign financing, which became much more volatile during 1972-82 than it had been earlier.

2. Trade Cycles, Policy Responses, and Fiscal Cycles

At this stage of analysis, it is instructive to survey the developments in the fiscal and external sectors of the 18 sample countries over the two recent world trade cycles during 1971-82 (Table 5). Since the fluctuation of fiscal balances is, in an important way, the product of the interactions between external developments and fiscal policy, a brief discussion of the policy responses to external shocks would provide a useful background for the subsequent description of external and fiscal developments.

Table 5.Eighteen Developing Countries: Fluctuations of Fiscal and External Balances During the Two Recent World Trade Cycles, 1971–821

(Percentage of GDP)2

1971–761977–82
ExpansionContractionExpansionContraction
197119721973197419751976197719781979198019811982
Fiscal balance
Deficit5.14.34.83.55.97.05.56.87.48.68.39.5
Revenue18.018.118.119.419.918.619.720.221.221.522.021.7
Expenditure23.122.422.922.925.825.625.227.028.630.130.331.2
External balance
Trade deficit9.07.56.411.913.98.58.19.79.014.516.315.2
Exports21.121.824.327.424.927.328.529.132.732.529.426.1
Imports30.129.330.739.338.835.836.638.841.747.045.741.3
Total trade51.251.155.066.763.763.165.167.974.479.575.167.4

During a period of large increases in export earnings and aggregate demand, the government may use fiscal policy to dampen aggregate demand by increasing tax rates or by restraining the growth of expenditure. If it adopts this cautious fiscal approach, the resulting improvement in the fiscal balance will lead to a reduction in bank financing and a slowdown in the growth of government debt. It could also lead to an accumulation of domestic or foreign assets for use during the subsequent declining phase of the trade cycle and the ensuing increase in fiscal imbalance. But although this cautious approach is desirable from the standpoint of macroeconomic stability, its adoption depends on the government’s ability to resist political and social pressures to greatly expand government services in a period of rising revenue. These pressures are understandably intense because of, among other reasons, the growing population in many developing countries and the accompanying increase in the demand for services. The pressures will be particularly intense if the increase in export earnings is perceived by the public to be long lasting.

Policy options are more limited during the recessionary phase of trade cycles. A negative external shock, such as a decline in prices, can increase imbalances in both the external and fiscal sectors. The government can draw down financial assets accumulated during a revenue boom. In the absence of accumulated assets, the mix and the speed of policy responses depend on a variety of factors.

No imbalance, whether external or fiscal, arising from a lasting negative shock can be financed indefinitely. The government can restrain expenditures and rely on nominal and real devaluation to improve its external balance. Devaluation will increase revenue if ad valorem export and other related taxes are a dominant part of revenue. If import duties and other taxes on imported goods are dominant, and particularly if these taxes are specific, much of the positive impact of the devaluation will be offset by a decline in imports and import-related taxes. The devaluation will also increase the nominal value of expenditure on government imports and foreign interest payments. Indirectly, it would also raise government spending on goods and services, including wage payments. The net impact of a devaluation on the fiscal balance depends on many factors, including the share of trade taxes in revenue, the shares of imported goods and interest payments in expenditures, the character of the tax system, the extent of domestic inflation generated by the devaluation, and the extent to which public sector wages and salaries are indexed to inflation.

The government can also attempt to increase tax revenue by raising tax rates. Experience suggests, however, that such a policy is often difficult to implement effectively as a short-run fiscal adjustment measure. First, the weakness in tax administration in most developing countries precludes the effective implementation of higher tax rates; an increase in export tax rates can lead to increased tax evasion, rather than increased tax revenue, particularly when the export industry is suffering from an adverse external shock. Second, high tax rates, even if successfully administered, weaken the external competitiveness of the economy, either directly, when export taxes are imposed, or indirectly, when import duties are levied on imported inputs for export industries.

The fluctuations of both fiscal and external balances followed cyclical patterns during these periods. In the trade cycles, a lag of about one year between the peaks in exports and imports is noted.6 During the 1971-76 cycle, a downturn in exports took place in 1975, whereas a significant downturn in imports took place in 1976. During the 1977-82 cycle, a significant downturn in exports took place during 1981-82, and a major downturn in imports in 1982, although this observation is tentative because the 1977-82 cycle should really be extended beyond 1982.

Fiscal cycles lagged trade cycles by about a year; revenue cycles lagged export cycles, possibly as a result of the usual lags in collection of taxes; and expenditure cycles tended to lag the revenue cycles. Thus, during the 1971-76 cycle, revenues continued to expand in 1975 and experienced a significant downturn only in 1976, whereas exports declined in 1975. Expenditure expanded at an accelerated pace in 1975 and declined only slightly in 1976. During the 1977-82 cycle, a downturn in revenue took place in 1982, whereas exports began to decline in 1981. Expenditure continued to expand in that year. Reflecting these cyclical movements of revenues and expenditure, fiscal deficits peaked in 1976 and again in 1982. During the 1971-76 fiscal cycle, the increase in deficits in 1975 was the result of a decrease in revenue not sufficiently offset by a small downward adjustment in expenditure. During the 1977-82 cycle, the increase in deficits in 1982 was the result of a decline in revenue reinforced by a continued increase in expenditure. During both the 1971-76 and the 1977-82 fiscal cycles, the adjustment of expenditure was slow and limited compared with the decline in revenue.

A more pronounced cyclical picture of fiscal balances is obtained by normalizing the timing of the cycles—that is, by averaging the fiscal balances across the sample countries after adjusting for the slight difference in the timing of the cycles among the sample countries. As shown in Table 6, the fluctuation becomes more pronounced, but the same broad conclusions emerge. Revenue cycles lagged export cycles for a number of reasons, including administrative lags in tax collection. The movements of revenue and deficits indicate that the adjustments in expenditure following the downturns in revenue were not sufficient to contain deteriorations in fiscal balances.

Table 6.Eighteen Developing Countries: Fiscal Developments During the World Recessions of 1975 and 1981–82(Percentage of GDP)
1975 Recession1981–82 Recession
Years

preceding

expansion
RecessionYears

preceding

expansion
Recession
1972-7419751978-801981-82
Revenues1
Average1.7−2.12.8−0.7
Standard deviation1.63.93.61.3
Deficits1
Average−0.32.20.6
Standard deviation2.64.44.62.6
Export developments
Exports
Average2.1−2.61.2−3.9
Standard deviation2.55.32.85.0

One notable phenomenon observed during the 1972-76 cycle is the sharply larger dispersion of changes in revenue, deficits, and exports across the countries in the recession phase of the fiscal and trade cycles than in the expansion phase. Apparently the extent of the declines in exports and revenues was more heterogeneous than the increase among the countries. This phenomenon is not observed during the 1978-82 cycle, but then the data do not cover the complete phases of that cycle, which was extended beyond 1982.

IV. Anticipation, Fiscal Discipline, and Fiscal Fluctuation

1. Government Revenue and Fiscal Cycles

The fairly well-synchronized cycles of fiscal balances and trade in most of the sample countries originate in the institutional setting in which the government relies heavily on the external sector for its revenue. The external factors often encompass not only exports but also the availability of credit, the cost of credit, the availability of foreign grants, and import prices.7 The following tests are based only on merchandise trade. For the time-series test summarized in Table 7, revenues are regressed on current or lagged exports and total trade values, with or without a time trend. The estimated coefficients are statistically significant at the 5 percent level for 14 of 18 sample countries, and at the 20 percent level for 15 of 18 countries. For the cross-section test summarized in Table 8, the index of fluctuation of revenue is regressed on the index of fluctuation of trade value. The result indicates a positive correlation between the fluctuations of revenue and trade across the sample countries. Against the institutional setting described above, together with the time-series evidence, this correlation should be interpreted as an indication of the impact of trade instability on revenue instability. In the regression for the period 1962-82, the coefficient of the variable representing the fluctuation of trade value is statistically significant at the 5 percent level; for the sub-period 1972-82, when the fluctuation of trade values became more volatile, the coefficient becomes even more significant.

Table 7.Eighteen Developing Countries: Time-Series Results for External Trade and Government Revenue, 1964-82
Regression of Revenue on1
Results for

Total Sample
ExportsTotal

trade
Cases with

time trend

included
Adjusted R20.440.500.32
Coefficients
Average of estimates0.240.240.072
Number of countries186125
Statistically significant at:
1 percent7344
5 percent14595
10 percent14595
20 percent155105
Not significant at
20 percent3120
Table 8.Eighteen Developing Countries: Cross-Section Results for External Trade and Government Revenue, 1962–821
Regression of Fluctuation of Revenue on Fluctuation of Trade Values
Coefficients
Sample

Periods
ConstantFluctuation of

trade value
Dummy2SEE3Adjusted R
1962-820.610.18*−7.02*1.370.23
(1.02)(2.67)(−2.43)
1962-710.900.09−1.461.580.02
(1.90)(1.52)(−7.99)
1972-82−0.220.37* *−7.421.180.41
(−0.35)(3.69)(−3.13)

Is it possible that the trade cycles were a consequence, rather than a cause, of the fiscal cycles? It is conceivable that expansionary fiscal policies caused a deterioration in external competitiveness, erosion of the revenue basis, and ultimately fiscal crisis. Alternatively, expansionary fiscal policy, itself, might have originated in the trade cycles. For example, the world recession might have necessitated increases in government expenditure for the alleviation of the adverse impacts of the recession on the economy, in general, and on the poor segment of the population, in particular. These two channels are plausible, but obviously different from the channel—running from external developments, through changes in revenue, to the fiscal fluctuation focused on in this paper. It should be noted, however, that even in the first of these alternative channels, the role of the government’s anticipation of external developments in the formulation of fiscal policy cannot be overemphasized. Furthermore, the synchronization of the fiscal cycles among the sample countries in relation to the world trade cycles indicates the importance of external developments in fiscal cycles and fiscal crises. For the second of the two possible channels, which was mentioned above as plausible, the correlation between the fluctuations of revenue and expenditure should be negative, since a world recession induces a revenue shortfall (resulting from a smaller tax base) and an excess in expenditure (resulting from anticyclical fiscal policy). The positive correlation between revenue and expenditure for most sample countries suggests that expenditure has been, to a certain extent, an important policy instrument for fiscal adjustment rather than for anticyclical economic stabilization.

2. Fiscal and External Imbalances and Government Expenditure

In this section, the process according to which government expenditure was determined in the 18 sample countries is examined. Ideally, the key hypotheses underlying the model should be tested by designing more country-specific structural models. This section focuses on analyzing the fluctuation of fiscal balances in a fairly large number of sample countries. Therefore, the analytical framework is made simple and uniform for all the sample countries. This simple relationship may be written as

where

Δgt = change in total government expenditure

fbte = anticipated fiscal imbalance, defined as the difference between the anticipated fiscal balance and the target balance

ebte = anticipated external imbalance, defined analogously as in the fiscal imbalance

dst = unanticipated component of an external shock

and

t = time

Total expenditure includes the target component: in equation (3), the change in this target component is captured by the constant, θ0, and any acceleration or deceleration is captured by the time trend with a constant coefficient, θ1. It should also be recalled that the anticipated imbalances, fbte and ebte, are assessed at the optimal levels of the policy instruments based on the anticipated external shock.8

Equation (3) postulates that government expenditure is determined partly as a result of a systematic drift in its target component and partly as a result of the optimization process. The first two terms reflect the change in the target component, the next two terms the fiscal response to the anticipated shock, and the last term a fiscal response to the unanticipated shock.

In testing the model empirically, a number of further simplifying assumptions have to be made.

First, the government is assumed to regard a certain level of fiscal and external (current account) deficits as sustainable and to regard any deviations of fiscal and external balances from these sustainable deficits as imbalances. The anticipated imbalances are the deviations of anticipated fiscal and external balances from these sustainable levels. The unanticipated shock is defined as the deviation of revenue from anticipated revenue. Therefore, the fiscal and the external imbalances and the unanticipated shock in equation (3) may be written as

where bt, cabt, and rt denote, respectively, the fiscal balance, external balance, and revenue as percentages of GDP, with superscript e indicating an anticipated value and the bar (—) over a variable indicating a sustainable level.

Second, the government is assumed to form anticipations by looking backward. Specifically, the government is assumed to anticipate the fiscal and the external current account balances and revenue on the basis of the following autoregressive equations:

Therefore, equation (3) may be rewritten as

On the assumption that the targets for fiscal and external deficits are constant, the model may be estimated by regressing the change in expenditure on time, anticipated fiscal and external balances, and unanticipated revenue shock. In addition, possible asymmetric responses of expenditure may be tested by introducing dummy variables into equation (3). For example, possible asymmetric responses of expenditure to either an improvement or a deterioration in the anticipated fiscal balance may be tested by replacing θ2bte by θ2bte+θ2bted1t where d1t takes the value 1 for the period of an anticipated fiscal improvement and -1 for the period of a deterioration. Similarly, possible asymmetric responses to the unanticipated revenue shock may be tested by replacing θ4st by (θ4st + θ′d2t), where d2t takes the value 1 for the period of a revenue excess and -1 for the period of a revenue shortfall.

The constant term and the coefficient of the time trend in equation (3) cannot be straightforwardly interpreted, because they reflect not only the trend component of expenditure but also the target levels of fiscal and external deficits. The coefficients θ2 and θ3 of bte and cabte in equation (10) would reflect the responses of expenditure to the anticipated fiscal and external imbalances.

Note that, in estimating equation (3) for each of the 18 sample countries, not all of the coefficients are necessarily expected to be statistically significant for all of the sample countries. On the basis of several key assumptions maintained in the specification of the model, statistical significance of the coefficients θ2 and θ4 would suggest the presence of fiscal discipline in the particular sample country. Given the statistically significant coefficients θ2 and θ4, the magnitude of the coefficients would suggest the extent of fiscal adjustment necessary in view of a given magnitude of fiscal imbalance. The explanatory power of the equation may not necessarily be high for all countries, since many variables other than those considered in the framework of the optimization may also be important determinants of government expenditure. The regression would indicate correctly the extent to which government expenditure was determined by the variables included in the equation, as long as the omitted variables were not correlated with the variables included in the equation.

Table 9 summarizes the results of the tests conducted on the basis of the data for the sample countries. The results for equation (3), without the external-imbalance term or the asymmetry dummies, are summarized in Part A. The adjusted coefficients of determination average 0.35 for the sample countries, suggesting that a substantial, although not overwhelming, part of the fluctuation of expenditure is accounted for by the variables included in the equation.9 It is not surprising that large variations in government expenditure are left unexplained. Fiscal responses to external shocks were diverse, as suggested by the large dispersion of fiscal deficits and expenditures across the sample countries that was discussed in Section III.10

Table 9.Seventeen Developing Countries1 : Factors Underlying Changes in Expenditure, 1967-82
Test of Statistical Significance

At Level of

(in percent)
Estimated2

Coefficient
201051
A. Symmetric Responses Assumed
Systematic drift
Time trend65320.14
Responses to shock
Anticipated fiscal imbalance75310.26
Unanticipated revenue shock11101070.92
Adjusted R20.35
D-W2.09
B. Symmetric Responses Tested
Systematic drift
Time trend86320.22
Responses to shock
Anticipated fiscal imbalance87420.53
Of which: countries for which the asymmetry dummy is significant3310
Asymmetry dummy4420−0.04
Unanticipated revenue shock10101060.88
Adjusted R20.40
D-W2.07

At the 20 percent level, the coefficient of the time trend is significant for 6 of the sample countries. The coefficient of the anticipated fiscal imbalance is also significant for 7 countries, and that of the unanticipated revenue shock is significant for 11 countries. At the 5 percent level, the number of countries for which the coefficients of the time trend, anticipated fiscal imbalance, and unanticipated revenue shock are reduced, respectively, to 3, 3, and 10.

The estimated coefficients of the anticipated fiscal imbalance and the unanticipated revenue shock average, respectively, 0.26 and 0.92. These estimates suggest that, on average, the adjustments of government expenditure were only 26 percent of the anticipated fiscal imbalances and 92 percent of the unexpected revenue excesses or shortfalls.11

Possible asymmetric responses of government expenditure are tested as follows. First, equation (3) is re-estimated with an asymmetry dummy variable for the unanticipated revenue shock variable. The results do not support the hypothesis that expenditure responded asymmetrically to the unexpected revenue shock. Second, the asymmetry dummy variable is replaced by an asymmetry dummy variable for the anticipated fiscal imbalance. Part B of Table 9 summarizes the results of this test. The results confirm the dominant role of the unanticipated revenue shock in the fluctuation of expenditure. The evidence is weak on the role of anticipated fiscal imbalances in the fluctuation of expenditure and possible asymmetric responses of expenditure to changes in such imbalances.

Thus, at the 20 percent level, the coefficient of the anticipated fiscal imbalance is statistically significant for 8 of the 18 sample countries; for 4 of these 8 countries, the asymmetry dummy variable is significant; the coefficient of the unanticipated revenue shock is significant for 10 countries. At the 5 percent level, the coefficient of the anticipated fiscal imbalance is statistically significant for 4 countries, and the coefficient of the unanticipated revenue shock is significant for 10 countries. The coefficients of the anticipated fiscal imbalance average substantially less than one (0.53), whereas those of the unanticipated revenue shock average closer to, but still less than, one (0.88).

For a large proportion of the sample countries, government expenditure is found to have increased in a systematic fashion as a function of time. In the regression reported in Table 8, the coefficient for the time trend is statistically significant for 6 countries at the 20 percent level and for 3 countries at the 5 percent level. The coefficients average 0.14, indicating a significant tendency of upward drift in government expenditure not accounted for by the imbalance variables or the unanticipated revenue shock.

3. Policy Rule and Fiscal Performance

The extent to which the fiscal imbalance affects the formulation and execution of fiscal policy is an important determinant of the fiscal performance. Table 10 compares the long-run fiscal performances of the sample countries with the results obtained in the preceding subsection on the policy rule. For the 12 countries for which the coefficient of the anticipated fiscal imbalance or the unanticipated revenue shock is fairly significant (for example, at the 10 percent level), the deficits increased, on average, by 2.1 percent of GDP between 1962-71 and 1972-82. For the rest of the sample countries, for which the coefficient is not significant, the deficits increased on average by 4.9 percent of GDP. Thus, the countries that could be described as having been more fiscally disciplined are found to have experienced, on average, a smaller deterioration in the fiscal balance than the rest of the sample countries.

Table 10.Eighteen Developing Countries: Policy Rule and Fiscal Performance
Fiscal Performance Between
1962-71 and 1972-86
Number ofIncrease in
Policy RulesCountriesDeficitExpenditure
percentage points of GDP
Countries whose government expenditure responded significantly to anticipated fiscal deficit or unanticipated revenue shock122.15.5
Countries whose government expenditure did not respond to anticipated fiscal deficit or unanticipated revenue shock64.96.8

A similar result is also obtained for the increase in expenditure. Thus, government expenditure for the first group of countries increased by 5.5 percent of GDP, that for the second group by 6.8 percent of GDP.

V. Summary and Conclusions

This paper has explored ways of explaining growing fiscal deficits in developing countries and their increased fluctuations. The paper surveyed fiscal developments in 18 sample countries during 1962-82 and analyzed possible factors underlying the fiscal developments and their relative importance.

The importance of direct and indirect taxation of international trade in many developing countries makes it inevitable that external shocks will affect the fiscal sector directly and immediately. Trade instability directly affects revenue instability. In this institutional setting, fiscal policy is viewed as a result of an optimization process in which not only fiscal policy objectives and fiscal discipline but also a number of constraints may play critical roles. The constraints originate in the government’s imperfect foresight, technical features of public investment projects, and difficulties encountered in reaching political consensus. With weak fiscal discipline, incorrect anticipations concerning revenue developments may have important implications for both the long-term developments in fiscal imbalances and the fluctuation of fiscal balances.

In this paper, data for the 18 sample countries indicated a substantial deterioration in fiscal balances and their increased fluctuation during 1962-82. They also showed that the fiscal cycles closely followed the trade cycles, particularly around the times of the two recent world recessions (1975 and 1981-82). Thus, in each of the two fiscal cycles studied that included world recessions, an increase in revenue followed an expansion in trade, while a decrease followed a contraction. It was shown that an increase in expenditure followed the increase in revenue; downward adjustment in expenditure following the contraction of revenue was too slow and small to prevent major deterioration in the fiscal balance.

Empirical tests indicated that a substantial, though not overwhelming, part of changes in government expenditure can be explained by variables intended to reflect the government’s efforts to balance the need to contain the size of the fiscal imbalance against the need to maintain expenditure at a certain level. The results indicated that in a fairly large number of countries, expenditure responded to anticipated fiscal imbalances and unanticipated revenue shocks in a manner that contained the fiscal imbalance. The evidence of such responses was stronger for the unanticipated revenue shock than for the anticipated fiscal imbalance. The use of expenditure as an instrument to contain external imbalance was not evident. The test did not support the hypothesis that expenditure responses to fiscal imbalances could be asymmetric.

The negative results on the asymmetry hypothesis contradict the observations of the time series on aggregate trade, revenue, and fiscal deficit. These time series suggest that during the recent two major world trade cycles, downward adjustments in expenditure were slow and small compared with upward movements during periods of increasing trade and revenue; this observation of aggregate time series suggests that the downward rigidity of expenditure contributed to the persistent fiscal imbalances and fiscal crises. Therefore, in contrast to the results obtained from regressions, the behavior of the aggregate time series suggests that the long-run deterioration of fiscal balances may not be unrelated to the fluctuation of revenues and imbalances.

The larger fluctuation of expenditure than of revenue and the dominance of expenditure fluctuation as the cause of deficit fluctuation are noteworthy. The empirical analysis, however, indicated that the ultimate cause of deficit fluctuation and recurrent fiscal crises in developing countries was, in no small part, the unstable external environment.

On the basis of the particular anticipation scheme assumed in this paper, anticipated fiscal imbalances triggered less strong fiscal adjustment than did unanticipated revenue shocks for a large number of countries. This phenomenon indicates that the adjustment was short term and perhaps unduly costly. Although the results should be viewed as highly tentative, it may not be a coincidence that the long-run deterioration in the fiscal balance was significantly larger for those sample countries that did not respond to shocks than for those countries that did.

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Trade is not the only external factor (though it is a major one) with important fiscal implications. Other factors include the availabilities of foreign credit, grants, and investments. See Tanzi (1986).

The term “openness,” as used in this paper, refers to an economy’s dependence on external trade. Consequently, describing an economy as open does not necessarily indicate that it has a liberal trade regime.

For an analysis of the tax systems in a broader sample of developing countries, see Tanzi (1982). That paper shows that the importance of the taxation of international transactions is a fairly general characteristic of tax systems in developing countries.

Data cover only the central government. In some sample countries, the fiscal performance of the public sector could diverge substantially from that of the central government owing to the fiscal activities of the local government and public enterprises. All the time-series data used in this study are based on calendar years; exceptions are fiscal data for India, Kenya, and Pakistan.

The estimate of αri is

The deviations edit, erit, and egit are related by the identity

Therefore

The expected value of αˆri will be 1 if erit and egit are not correlated; it will be less than 1 if they are positively correlated, greater than 1 if they are negatively correlated. A similar proof can also be shown for αˆgi.

See Rangarajan and Sundararajan (1976); Hemphill (1974); and Chu, Hwa, and Krishnamurty (1983) for the role of exports in the determination of imports in developing countries where the level of imports is constrained by the availability of foreign exchange.

This institutional setting is emphasized in Tanzi (1982, 1986) for developing countries in general, particularly Tanzi ((1986), p.89), and in Morgan (1979) for oil exporting countries in particular.

A positive imbalance indicates either a surplus or a deficit smaller than the target deficit; a negative imbalance indicates a deficit larger than the target deficit.

The adjusted coefficients of determination average 0.41 for 12 countries for which the anticipated fiscal imbalance or the unanticipated revenue shock is found to be significant at the 20 percent level.

See Tanzi (1986) for discussion of the patterns of fiscal responses to external shocks in developing countries.

The estimation results of the same equation without the coefficient θ3 of the external-imbalance term constrained to be equal to zero are available; the anticipated external-imbalance term is not statistically significant for a large number of countries, and the other results are broadly the same as in Part A of Table 9.

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