chapter one Fiscal Policy Parameters for Budgeting
- A. Premchand
- Published Date:
- March 1989
“Would you tell me, please, which way I ought to go from here?” “That depends a good deal on where you want to get to,” said the cat.
LEWIS CARROLL, Alice's Adventures in Wonderland
Fiscal policy, which was traditionally concerned with the provision of services by government and the mobilization of resources needed for financing them, has undergone a transformation during the last five decades. It is now on the threshold of further changes. The fiscal machinery, in particular the techniques and procedures of budgeting, is being adjusted to meet the changing requirements of fiscal policy. An understanding of the fiscal policy is essential for gaining proper perspectives on the different aspects of budgeting. Therefore, this chapter is devoted to a consideration of the functions of fiscal policy and of its role in industrial and developing countries, recent issues in the conduct of fiscal policy and their implications for budgeting and expenditure controls.
Fiscal policy consists of the use of taxes, government spending, and public debt operations to influence the economic activities of the community in desired ways and is concerned with the allocation of resources between the public and private sectors and their use for the attainment of stability and growth. Although the effects of fiscal policy are extensive, they are particularly measurable in areas such as employment, price stability, savings and investment, and the balance of payments. Fiscal policy aims at using its three major instruments—taxes, spending, and borrowing—as balancing factors in the development of the economy. The use of the term here is limited because it excludes debt management, which is viewed as an integral part of monetary policy.1 Formulation of fiscal policy presumes the identification and clear recognition of the institutional aspects of government finance, such as tax systems, their incidence and shifting, budget formulation and execution, and financial management. The focus of budgeting is on the attainment of efficiency in the allocation of resources within the public sector and is influenced at each stage by the goals of fiscal policy. As this study aims to analyze the role and functions of budgeting and related expenditure controls, the following discussion on fiscal policy and its changing impact on the scope and operations of budgets excludes consideration of taxes as instruments of fiscal policy.
Dsevelopment and Functions of Fiscal Policy
The term fiscal policy came into popular use during the Great Depression. Until then, it was used (if at all) to denote a policy that affected the royal or public treasury. The policy itself was an extension of the prudent fiscal behavior expected of an individual for balancing his income and outflows. As Adam Smith put it, “What is prudence in the conduct of every private family can scarcely be folly in that of a great kingdom.” The application of the principle, however, involved a major difference that recognized the larger functions of the state and permitted it to borrow during such emergencies as wars. This approach, which governed the thinking during the eighteenth and nineteenth centuries, was given the most succinct expression by Bastable, who wrote toward the end of the nineteenth century, “[u]nder normal conditions, there ought to be a balance between these two sides … of financial activity. Outlay should not exceed income, … tax revenue ought to be kept up to the amount required to defray expenses.”2 On the same page he added a modification to this general principle, suggesting “[t]he safest rule for practice is that which lays down the expedience of estimating for a moderate surplus, by which the possibility of a deficit will be reduced to a minimum.” The guarantee of fiscal prudence lay in aiming at a moderate surplus so as to avoid the possibility of a budget deficit. The constraint of the balanced budget became a key operating factor for politicians and civil servants alike, and any departures from this approach were considered to be journeys toward profligacy that would erode the prosperity of the country and eventually lead to financial ruin. The approaches of budgeting naturally reflected this classic principle and were fairly simple. To put it into operation, a central agency—called finance—with no administrative or spending policies of its own, was organized to review the proposals of the spending departments. It was accepted that finance alone, which was charged with the responsibility for raising revenue needed for meeting expenses and, in a manner, filling up the financial reservoir, should also know the depth of this reservoir and outflows from it. The management of the taxpayers' contributions could not be left to the mercies of the spending departments, and a finance ministry or treasury was expected to provide a vigilant supervision of the activities of the spending departments. The primary responsibility of the central agency was to economize effectively and promote financial order within the government. The embodiment of the general principle of a balanced budget as the guiding star of the treasury was noted by Durell, who observed “[t]he public and the Parliament should be satisfied that somewhere or other in the government there is a guarantee for financial order; that there is some authority which will watch the progress of expenditure, the obligations which the different departments are incurring and will give timely warning if that expenditure or those obligations are either outrunning the revenue provided for the year or engaging the nation too deeply in future years.”3 Budgetary scrutiny and review therefore concentrated on the legality, propriety, economy, and efficiency of expenditures. Macroeconomic functions, as they have come to be subsequently known, were not a part of the lexicon of the operating budget officials; their approach was dominated by accounting and administrative considerations. From any point of view, it was a simpler world then.
This situation was, however, reversed in the 1930s when fiscal policy came into being in its own right. The onslaught of the Depression in 1929 raised a number of leading issues on the role and policies of government budgets. Initially, efforts were mainly directed toward combating the Depression, which had already gathered momentum, by providing money at lower costs in order to encourage investment. However, there was no increase in investment, as businessmen were reluctant to borrow and invest at a time when the profit outlook was dim. Money became cheap but proved ineffective as an instrument for inducing investment in the private sector. Households were not spending enough, nor were governments. The situation prompted the financial policymakers to envisage government deficits to reactivate the economy and to reduce the levels of unemployment. However, there was also the official view, reflecting in a way the continuing influence of the balanced budget approaches, that government expenditures financed by borrowing did not necessarily increase employment and could be construed as merely diverting resources that would have been otherwise invested by the private sector. It was in this context that the liberating ideas of John Maynard Keynes, and his advocacy of deficit spending, came to be considered.
Keynesian contributions have influenced economics in more than one sphere, and they may broadly be examined in terms of economic theory, as policy prescriptions to deal with unemployment and as a philosophy that believed in government intervention for managing the economy to minimize unemployment. Keynes pointed out that the fundamental cause of the Depression was the lack of spending. The decision to save in the household sector did not necessarily lead to a decision to invest, and the government therefore had to step up its expenditures in order to “prime the pump” of the economy. It was recognized that public borrowing absorbed private saving, but such borrowing contributed to greater economic activity, while money retained in the private sector would have more likely contributed to greater unemployment than to increased private investment. In Keynesian terms, budget deficits were viewed as positive instruments to shore up aggregate income to stimulate all sectors to spend more. Keynesian economics freed the thinking of the treasury from the narrow concept of balancing the budget to the wider role of balancing the whole economy. The Keynesian view of the state implied that it had both an obligation and an ability to control any instability in the economy and to restore functioning order.
The acceptance of these ideas ushered in a fiscal revolution. Budgeting ceased to be a mere tool of accounting and acquired greater dimensions. The increase in expenditure that accompanied the more active role assumed by the state brought with it a transformation in the size of the budget, since fiscal policy could be meaningful only when public expenditure comprised a substantial portion of the gross national product (GNP). Budgets have come to be linked with management of the economy, in turn bringing a greater consideration of the effects of expenditures on the economy. Past were the days when expenditures were considered merely in terms of type and the authorities responsible for incurring them. Now, it is also envisaged in terms of the multiplier effects of expenditures on incomes, consumption, saving, and investment. As most expenditures had come to be financed by borrowing from the public, it also became necessary to consider the productive capacity of the programs being financed in order to ensure future financial viability. The budgetary process, in due course, became more important, because here the administrative, accounting, economic, and financial objectives interfaced and collectively produced a coherent fiscal policy.
The spread of Keynesian economics did not help much in easing the problems emerging from the Depression. The Depression itself came to an end with the beginning of the increased expenditures for the preparation and actual conduct of World War II. Also, there was a substantial growth in expenditures, reflecting the expansion in the social functions of the state, and the operations of government had begun to have a magnified effect on the level of the overall demand. Increases in spending raised the level of demand, while increases in taxation (undertaken to finance the increased expenditures) reduced it. Thus, budget surpluses and deficits had different effects. Fiscal policy, which was viewed during the Depression as unidirectional, became two-dimensional as the instruments of taxation, expenditure, and borrowing could be used to control aggregate demand. Fiscal policy extended beyond its definition as a series of measures intended to provide compensatory action to fluctuations in private spending in the context of a trade cycle to the achievement of stabilization in the economy through its influence on aggregate demand. It thus had to contend with both recession and inflation.
The balance between aggregate demand and supply in the economy, which is the key for stabilization, is achieved through fiscal policy. An increase in the flow of money to the government, other things remaining equal, will lower aggregate demand while a decrease will stimulate it. The formulation of policies designed to achieve these subtle changes in the economy requires that there is, as a prerequisite, a detailed understanding of the linkages in the economy, the lags with which taxes and expenditures have an effect, and the magnitude of such effects. The determination of an appropriate level of aggregate demand is a formidable and complex task. In somewhat general terms, an appropriate level of demand is one that would ensure a reasonable utilization of productive capacity (and thus employment) while maintaining some price stability and sustaining an economy conducive to longer-term growth and an acceptable balance of payments position. These wide-ranging concerns cannot, however, be pursued, much less established, by fiscal policy alone and require active coordination with monetary, income, and balance of payments policies. More significant, however, is the fact that these objectives are not always reconcilable. Policies do not come in near packages with conflicts fully resolved. Conflicts among the objectives are real, and the adoption of any solution involves political repercussions. Such political fallout is only natural, because the real world is a world of politics. The level of aggregate demand is not immutable, and the impact of the budget depends not on the internal consistency of its accounts but on the nature and state of the economy. If the economy is characterized by inflation, the formulation of a balanced budget is unlikely to be of any use. Its contribution would be limited to the negative aspect of not adding any more inflationary pressures of its own. The budget will have to take into account the trends and magnitudes of consumer expenditures and use appropriate fiscal instruments. As the nature of the economy changes both in the medium term and short term, or even during the fiscal year, it is obligatory for the government to adjust its policies and to switch horses in midstream, if so required. Pursuit of stabilization as a goal of fiscal policy thus involves budgetary planning and a continual assessment of the dynamics of the working and impact of the budget. Traditional budgeting involved a reckoning for the next year with a degree of certainty in the economy. The future was obviously more certain when the only function of fiscal policy was to allocate funds for the limited range of services provided by government. As expenditures increased and as they became dependent not merely on the supply constraints but on the general economic climate, the uncertainty involved in budgeting also increased. This aspect imposed additional burdens on budgeting.
Management of aggregate demand is a short-term function of fiscal policy. Stability in a stagnant economy is of no consequence. Fiscal policy, therefore, has to aim at stability in a growing economy. Emphasis on growth, as discussed further on, has different implications in industrial and developing countries. In the former, the aim of fiscal policy is to ensure the full utilization of the capacity and productive use of the resources, while in the latter, fiscal policy has the aim of increasing the flow of savings to the government sector for financing development expenditure and for providing related infrastructure that in turn generates more growth. In the industrial countries, greater attention is also given to fiscal policy for maintaining full employment and minimizing the impact of cyclical forces. Fiscal policy is used, on the one hand, to stimulate demand and thus ensure a market for the goods and services produced, and on the other hand, to encourage the appropriate use of labor and capital to increase employment. Another use of policy is to make capital assets more expensive relative to labor by levying taxes on the use of capital-intensive technology and giving wage subsidies. The important consideration in all this, however, is the compatibility of these goals with that of economic stability.
Yet another role of fiscal policy is to minimize the adverse distributional impact of government policies. Traditionally, distribution has been analyzed in terms of factor shares (wages and capital income). However, in due course and particularly in the context of maintaining aggregate demand and higher levels of employment, it became apparent that while wages and capital income might be adequate at a national level, regional and sectoral disparities would persist and, in some cases, would even widen further. Therefore, intense pressures arose to reduce the regional disparities in racially diversified countries and the inequalities between rural and urban sectors. These pressures became a constant feature of current political discussion. The need for greater attention to these areas was self-evident in a context characterized by growing poverty in the developing societies and by lack of evidence that the process of economic development had had the desired impact on the lower classes. Another major factor was the recognition that the political realities would not permit a further widening of the distribution patterns.4 Although there is less convincing evidence that fiscal policy alone would be able to reduce the inequalities stemming from the existing operations of government—much less reduce the cumulative inequalities—it is clear, however, that in conjunction with other social reforms, it has considerable potential for this purpose.
Fiscal policy is so wide-ranging that selection of a combination of differing objectives is both complex and controversial. The impact of these objectives on budgeting is threefold. First, budgeting involves the identification and measurement of the impact of the budgetary operations on the economy, and of the economy on the budget, and the relationship of these operations to the overall objectives. Second, the objectives of fiscal policy can be attained through the instruments of taxes, expenditures, and, to an extent, the provision of credit. The effects of these instruments are not identical, and one task of budgeting is to ascertain the effects of each and to arrange the three instruments so that they collectively serve the purpose. Third, the objectives are served by direct government operations, through the activities of other levels of government, notably the state and local governments, and through the public enterprises at each level. Fiscal policy at a macroeconomic level requires close coordination among all three levels in all phases of the budgetary process.
Formulation of Fiscal Policy
Fiscal policy has acquired, over the years, the above-noted wide range of functions. But the actual policy at any given stage involves the transmutation of attitudes and approaches into specific responses to particular challenges that are recognized in the functioning of the economy. If insufficient weight is given to practical factors, policy formulation becomes a ritualistic exercise and implies an uncertain contact with reality. Thus, the very first task is the development of underlying aggregates that characterize the economy so that their nature and magnitude can be perceived and assessed, to the extent possible, in quantitative terms, by planners and politicians alike. While different perceptions are inevitable, since each decision maker is influenced either explicitly or implicitly by his hidden or revealed social preferences, the aggregates and their analysis permit a framework within which the objectives and the means available for reaching them can be considered. Not all objectives can or need be pursued with the same vigor. Some are obviously more important than others; some are of a short-term nature, while a few others would involve a continued allocation of resources over a sustained period. Some are better achieved through the encouragement of the private sector, while a few tasks can be undertaken only in the public sector. The political sensitivity of some proposals reduces their attractiveness. The fiscal policy to be pursued in any year therefore involves a reckoning of an infinite number of factors; conscious and deliberate planning is needed to reconcile the objectives into a workable compromise. The formulation of fiscal policy should take into consideration the range of the instruments and their relative efficacy in performing given tasks. Much is dependent on the analytical capability of the administrative system and the skill and foresight shown by the administrators.
The second major task relates to the determination of the resources to be acquired by government from the private sector and to the maintenance of balance between public and private sectors. Resources needed by government are partly determined by its expenditures and partly by its stabilization and distributional goals. These, however, are not independent factors but are drawn from the perceptions of those who are entrusted with the political responsibility of administering the country. The balance between public and private sectors is primarily a political choice and is influenced by several considerations. The process of making this choice is complex and has always been controversial. The typical textbook examples of a pure market economy with private enterprises or of totally centrally planned economies with state enterprises are rarely found in the real world. In practice, therefore, the issue is one of determining the relative boundaries and the duration for which such lines of demarcation should remain in force. As noted earlier, the role of the state had come to be dominant in an economic sense, and its functioning as a stabilizing agent is deeply rooted in Keynesian economics, in the belief that the government has an important role in the management of the economy.
The third aspect of fiscal policy formulation is related to the consideration of the instruments appropriate to attain the specified objectives. Viewed in terms of government expenditures, the objectives discussed in the preceding section, their determinants, and the instruments available are illustrated in Table 1. Collectively, the choice of the relevant instruments and the allocation of necessary funds form the heart of budgeting. The significant change that budgeting has undergone—with the transformation of fiscal policy from the goal of balanced budgets to the goal of balance in the economy, to the promotion of growth, and to lessening distributional inequalities—is in the use of strategic economic planning, in addition to the traditional functions of financial and managerial control. The new role of budgeting consists of the determination of the kind and level of activities that are sought to be carried out by governments.
|Objectives||Determinants of Objectives||Expenditure Instruments|
|Provision for social wants||Sociopolitical approaches||Consumption expenditures incurred in the provision of public goods and services; investment outlays on the production of goods; and provision of general, social, and economic services|
|Optimal growth||Socioeconomic imperatives||Investment expenditures; other outlays on the provision of infrastructure facilities; and loans to private sector|
|Employment||Socioeconomic imperatives||Investment in labor-intensive industries; subsidies; and related fiscal incentives|
|Stabilization or demand management||Economic factors||Reductions or increases in expenditures; changes in the composition of expenditures and methods of financing budget surpluses and deficits|
|Distribution of income||Sociopolitical approaches|
|(i) among people||Transfer payments; direct and indirect subsidies; provision of goods and services free to specified income groups of the community|
|(ii) among regions||Investment in less developed regions; greater subsidies and grants|
Application of Fiscal Policy: Industrial and Developing Countries
What is the role and applicability of fiscal policy in the industrial and developing countries? How is it used? What are its limitations? These are some of the issues that require examination, if only because they provide the relevant parameters within which the system of budgeting functions. Economists have, over the last three decades, used several terms to indicate the broad economic groups of countries. In order to categorize the nonindustrial countries for determining the relevance of the new fiscal policy approaches, newly emerging nations were described as “undeveloped,” “underdeveloped,” “less developed,” or “developing” countries. In the recent literature on budgeting, a distinction is made between “poor” and “rich” countries.5 For purposes of analysis here, however, the distinction between industrial and developing countries is used. It should be noted that the category “developing countries” covers a wide variety of economic systems at different levels of economic development. Although dichotomous approaches or broad groupings have inherent limitations, they are utilized here in discussing convenient benchmarks for considering the relevance of fiscal policy.
In the early days of the development of fiscal policy, when it was still used to prevent a depression, it was assumed that the same technique could be used in both industrial and developing countries. But this assumption proved to be incorrect, in view of the differences in the relative levels of development. Fiscal policy in industrial countries was first identified with reducing unemployment by stimulating demand through deficit spending. During periods of weak demand, industrial countries have large pools of unemployed productive resources, including underutilized capital equipment and managerial skills, and fiscal policy can minimize the cyclical impact through the maintenance of aggregate demand. The leading cause of business cycles in these economies is the fluctuation in demand, and once the pump is primed through public sector spending, the underutilized resources can be rapidly put back to use for increasing production. The situation is different in the developing countries, where unemployment is chronic and reflects structural bottlenecks of the economy rather than those that are cyclical in nature. In the developing countries, injection of increased purchasing power, as is the practice in industrial countries, tends to work itself out through increased imports and increases in prices rather than leading to increased production.6 It is primarily for this reason that fiscal policy is used in developing countries as an integral part of development plans, with the aim of making appropriate structural adjustments in the economy. Achievement of growth is necessarily a long-term task, and more reliance is placed on fiscal policy in developing countries because of the features associated with the working of the monetary policy. Lack of financial markets, or relatively well developed ones, and the existence of large nonmonetized sectors in the economy have tended to reduce the efficiency of monetary instruments, shifting the major burden of adjustment to fiscal policy. Also, the dominant role assigned to public sector operations in the development process necessitates greater reliance on fiscal policy.
Fiscal policy is also used in developing countries to counteract inflationary pressures. Fluctuations in developing economies occur primarily because of variations in agricultural yields and their prices. An increase in the export prices of primary commodities will bring with it increases in income—and in turn increases in imports and in prices, reflecting the expansionary influences. Fiscal policy may then be directed to mopping up the increases in real income and to diverting for use in financing economic development. A variation of this theme occurs in oil exporting countries. Increased incomes emerging in oil producing countries from oil price increases in 1973 contributed to enormous inflationary pressures there, as the absorptive capacity of the economy was limited and as the increased revenues of the government budget were spent on the salaries of government employees and others. Consequently, the oil exporting countries were forced to undertake major austerity programs and expenditure adjustments in their budgets to contain the inflationary impulses generated in the process of utilizing the suddenly stepped-up oil revenues. In primary producing countries, a drop in the export prices is mitigated through the removal of the taxes levied when prices were high or through the pursuit of an expansive fiscal policy when foreign reserves or external credit are available. This is not to suggest, however, that adjustment in either direction is easy or is without problems, but it is illustrative of the two-way usage of fiscal policy during the short term.
The role of fiscal policy in the long run in developing economies is more positive, in that it seeks to reflect the aspirations of all developing countries. Emphasis on the expansion of productive capacity, on large expenditures for development purposes, on projects that are more viable from the point of view of social return than financial return, and on the attainment of a more equitable distribution of income has become a part of the accepted development strategy of these countries. Fiscal policy, in this context, is geared to the mobilization of revenue resources, to their allocation among competing priorities, and to ensuring that the broad directions of the movements in the economy are in conformity with national aspirations. Particular emphasis is laid on the financing of the budget in such a way that no new inflationary pressures are generated. Financing the budget deficits has been a matter of considerable debate ever since development planning was formally organized. It is contended that the amount of noninflationary finance in developing countries available for development is generally limited and that, therefore, resort to deficit financing is inevitable. The problem, however, is that if such deficit financing is undertaken without regard to its effect on the money supply and on the availability of resources, it will inevitably lead to inflation and hamper the achievement of the plan. This does not necessarily mean that a balanced budget should be pursued for its own sake. The more practical budgetary problem is to determine how much deficit financing is proper within the envisaged policy framework and at what point it becomes excessive. It is, therefore, a matter that needs to be decided, not with reference to doctrinaire considerations but on a more pragmatic basis in the light of the assessment of the potential of the economy. The view has been advanced, however, that, beyond a point, inflation is the only practical way of transferring command over resources to the public sector; before it reaches that point, it is helpful in minimizing the levels of unemployment and providing a moderate basis for growth in the economy, and as an implicit tax it offers revenue to the government. The tenability of these approaches, as experience suggests, is more than suspect. Inflation is fairly inefficient as a tax, and as a source of financing plans for growth it can be sustained only as long as the net returns from government investment are very high.
The role of expenditures in fiscal policy is partly dependent, as noted earlier, on their overall ratio to GNP and partly on their functional and economic characteristics. Government expenditures can be divided for analytical convenience into those for (a) traditional public goods and merit wants (defense, education, etc.); (b) direct trading and industrial activities of governments; (c) transfers to productive sectors (e.g., industries, agriculture); and (d) transfers to households and individuals. Admittedly, each is dependent on the political perceptions of the state and on the reliance placed on the market system. For purposes of comparison, however (although it should be recognized that international comparisons have limitations), a profile of government expenditures in selected industrial and developing countries is provided in Table 2. It appears that, reflecting the general emphasis on expenditures for development, countries in the developing world spend more on economic services, ranging broadly from a fifth to a third of total expenditures, while the corresponding outlay in industrial countries is relatively minor. Defense expenditures do not lend themselves to any clear conclusion, owing to the cost-sharing arrangements of alliances and to the geopolitical forces at work. Outlays on education and health tend to be higher in developing countries, in turn reflecting the direct involvement of the state in the provision of social services.7 Although the expenditure data shown in Table 2 do not show the needed detail, it appears that expenditures on trading and industrial activities tend to be higher in developing countries in view of the role of the public sector in economic development. An important distinguishing feature is that, in industrial countries and some developing countries in the Western Hemisphere, a greater share is claimed by transfers to households and individuals, reflecting the widespread prevalence of social security systems.8 These transfers constitute more than half the expenditures in industrial countries and have given rise to problems in the formulation of fiscal policies because they have shown a persistent tendency to increase and therefore have ceased to be of much value as a countercyclical measure.
|Education,||By Economic Type|
|Germany, Fed. Rep. of||1978||10||21||9||3||55||6|
A dash indicates data are not available for the year shown; all figures are shown as percentages of total expenditure of the central government and have been rounded.
A dash indicates data are not available for the year shown; all figures are shown as percentages of total expenditure of the central government and have been rounded.
Working of Fiscal Policy
Since the end of World War II, there has been a phenomenal growth in public expenditures throughout the world. During the initial period, the causes of growth in the relative magnitudes of expenditures were primarily social and political rather than economic in character. The spread of democracy imposed new obligations. The more democratic a country's political system, the greater was the incentive for the leadership to provide services that would satisfy the wishes of the community. Empirical surveys of these expenditure increases have not paid sufficient attention to the policy factors. Democratic goals of reaching a wider section of the community have contributed to the adoption of income maintenance and related programs to help the vulnerable and socially disadvantaged classes of people. Social insurance programs, which were introduced in the west European countries at the turn of the century, and which reflected the complex relationships between the growth of labor unions and the prevailing ideologies, were extended further. There was also an expansion in social benefits. The social security system was introduced in the United States much later but the benefits gradually came close to European levels. The base of the public education system was first broadened in America and soon emulated by European countries. Europe showed greater commitment than the United States at the government level in providing housing and improved medical facilities, leading to the concept of a welfare state that came to dominate the planning—and, in fact, became the central theme—in developing countries. Increases in expenditures reflected the changes in the multiple roles of government as consumer, producer, distributor of income, employer, and investor. The new government forms and the scope of their operations changed so much that they no longer conformed (if they ever did conform) to the textbook models.
A number of economic factors also contributed to rapid increases in public expenditure. A statistical survey of the factors and their relative importance is, however, outside the scope of this study.9 Broadly, the external variables that have had a decisive influence on budgetary magnitudes include (1) the growth and change in the age structure of the population and (2) the income elasticity of demand, which implies that the demand for public services tended to increase with rising individual incomes. In industrial countries some growth in expenditures is also attributable to the availability of greater tax revenues during the initial phase of inflation. These revenues permitted expenditure commitments that would presumably not have been made otherwise. On the supply side, the working of the relative price effect (which implies that prices paid by the public sector have risen faster than inflation), the indexing of certain kinds of benefits, and greater outlays following the sharp rise in oil prices have all added to the growth of public expenditure. These factors have admittedly been uneven in their incidence, as is reflected in the varying rates of growth and in the specific components of expenditures (such as transfer payments, consumption, and capital formation) among countries. Although there is no single scientific theory that can fully explain the growth in public expenditure, it is clear, however, that the social forces which molded the form of government—and the economic forces operating through the political and organizational processes—have contributed to a situation in which expenditure increases have been continuous and have come to claim an increasing share of GNP.
The financing of the growth in expenditures made obligatory further efforts toward raising more revenue. Countries in both the industrial and developing world have frequently adjusted their tax rates, and the overall tax rates have increased over time. In some countries, the rate of increase in taxes was more than the rate of growth in GNP, but this was necessary for financing the expenditure requirements. However, as revenues lagged behind expenditures, budget deficits become larger in some countries. Table 3 provides selective data on the state of public finance during 1950–75 for 7 industrial and 15 developing countries. It should be noted, however, that these data refer only to the budgetary flows and do not take into account off-budget spending and borrowing. Also, the coverage of the budget in some countries has changed from time to time, reflecting the decentralization efforts to pass on more revenue and expenditure responsibilities to the state and local governments. The data reveal that industrial countries generally had budget surpluses in 1950, and where there were deficits, the magnitude was small. The situation did not radically change throughout the decade and, except for the Federal Republic of Germany and the United Kingdom, the others had surpluses. By 1965 the picture was one of a frightening uniformity of deficits. For purposes of fiscal policy, however, the budgetary magnitudes are best seen, not in absolute terms but as percentages of gross domestic product (GDP). Analysis of the budgetary data in terms of GDP suggests that the United Kingdom, which had a surplus in 1950 of about 2.6 percent, had a deficit of about 8 percent of GDP in 1975. The trend in the developing countries, as shown in Table 3, with the exception of Burma and Zambia, has been one of steadily increasing budget deficits. Steep acceleration in the growth of budget deficits is particularly noteworthy in Jamaica (from I percent in 1960 to 8 percent in 1975), Pakistan (from 11 percent to 23 percent), the Philippines (15 percent to 19 percent), and Tanzania (whose deficit increased in the five years 1970–75 from 4 percent to 10 percent of GDP). Zambia, which had budget surpluses in 1965 and 1970, incurred a budget deficit by 1975 that was equivalent to a fifth of its GDP.
|D||+ 0.60||+ 0.12||0.25||0.02||1.0||6.28|
|D||10||205||+ 367||+ 1,063||+ 3,549||8,042|
|D||+ 352||114||+ 298||1,117||1,319||6,406|
|D||+ 339||446||307||610||+ 670||8,376|
|D||2.2||2.7||+ 0.2||1.6||+ 5.5||75.4|
|D||+ 165||+ 125||+ 223||+ 502||—||571|
|D||—||—||+ 8||302||+ 59||948|
|D||—||—||—||+ 24.2||+ 23.4||298.4|
Data are in countries' respective currencies: revenues include grants received. Data are not consistent for the period and have not been adjusuted for changes in the scope and coverage of the government budget. Data relate to central governments only.
Legend: R = Revenues
E = Expenditures
D = Deficit. Surplus is indicated by a plus sign.
Data are in countries' respective currencies: revenues include grants received. Data are not consistent for the period and have not been adjusuted for changes in the scope and coverage of the government budget. Data relate to central governments only.
Legend: R = Revenues
E = Expenditures
D = Deficit. Surplus is indicated by a plus sign.
The financing of budget deficits could, in theory, be done in one of three ways: (a) by issuing more money, (b) by borrowing from the public or from abroad, and (c) through the balanced budget multiplier mechanism by maintaining the budget deficit constant and by financing the increase in expenditures through increased taxation. The last technique did not have much practical impact, however, as the additional revenues were less than the increases in expenditures. Reflecting their structural differences, industrial countries showed greater reliance on borrowing from the public, while the developing world took the path of credit expansion. The high budget deficits financed by borrowing from the domestic banking system contributed to excess demand and rising prices at home which spilled over to imports. As costs and prices rose relative to foreign prices, export and import sectors contracted and the balance of payments deteriorated.
The role of fiscal policy in the above situations is to aim at stabilization of the economy through measures to counteract the negative influences and restore better economic conditions. Stabilization policies emphasize the need for corrections in the government budget by limitations on credit to government, acquisition of new debt, and mobilization of additional budgetary resources from increased revenues or reduced expenditures. The choice of policy instruments is primarily influenced by the identification of the precise causes of deterioration and the likely effects of different policy instruments. Such stabilization-oriented fiscal policies were broadly followed during the 1950s, 1960s, and 1970s. During this three-decade period, conscious efforts were made to manage aggregate demand and the economy by short-term adjustments in fiscal policies in conjunction with other policies. If, however, the effects of these policies are seen in terms of the size of the budget deficits during 1975 and thereafter, it might appear that the stabilization policies did not have the desired effect. Recent analysis of international experience with stabilization suggests that it is more of an art than a science and that both policy and institutional factors can and do stand in the way of appropriate managment of the economy.10
At a policy level, fiscal instruments were used frequently to fight recessions, with the short-term emphasis on growth and employment objectives. Although taxes were to be imposed to reduce budget deficits and to reduce the inflationary pressures generated in the process, their mobilization was a problem in view of public resistance and related political costs. Reduction in expenditures posed even more complex political dilemmas, and there was a perceptible reluctance to tackle the problem. This was sought to be compensated for to a certain extent by limitations on the expansion of credit and through incomes policies aimed at restraining wage increases. These approaches were not followed with any consistency, however, and frequently restrictive fiscal policies were followed by inflationary policies for creating employment and promoting growth to repair the political damage done. These periodic swings only created new problems. Since the reversal in policies took place too swiftly, it appeared that the fiscal restraint adopted for controlling inflation had little effect on it and actually worsened unemployment and investment. Conversely, the fiscal stimulus thought necessary for reducing unemployment exacerbated inflation and had an uncertain impact on growth and investment. The available evidence suggests that the reliance placed on fiscal policies for managing the economy was in part based on the success that such policies had in the early 1950s and 1960s—success that is attributable to the relatively stable growth rates of the period, coupled with growth performance. When these conditions changed, the success of the stabilization policies became doubtful. The policies were often too ambitious and measures were put into effect too late. At the institutional level, policies were formulated on faulty economic forecasts and with insufficient recognition of the time lags with which fiscal policies work. In sum, the efficacy of fiscal policy for managing the economy in the short term became seriously doubted by the mid-1970s.11
The trends shown in Table 3 for 1970–75 have continued since then, with a few minor exceptions, as a global phenomenon. The persistence of the growth in expenditures, increasing deficits, and difficulties in raising resources have given rise to serious questions on the direction of fiscal policy and on the institutional adequacy of the budget machinery for controlling expenditures. The issues reflect, as they inevitably would, the economic and political convictions of those who espouse them. Some of the points mentioned below are associated with the monetarist school, some with the public interest school of public expenditure, some with those who belong to neither school but have profound views on the current issues faced by society, and some reflect the analysis of fiscal practitioners. For convenience sake, they are examined in terms of those relating to taxes, expenditures, and the financing of the budget deficits.12
The increase in taxation, which, it is contended, had become necessary following the expenditure growth, had disincentive effects throughout the economy by holding back the growth of output. Double-digit inflation magnified an already adverse tax treatment of income from capital, eroding the incentives to save and increasing the financial costs of investment. Moreover, increases in indirect taxation contributed to increases in retail price indices, which, apart from their effects on wage negotiations, have also made exports uncompetitive and unrewarding. The tax burden had a tendency (although this was not always proven) to confer a premium on nonmarket activities (barter and the underground cash economy or leisure and public welfare) and to increase the attractiveness of less-taxed work. More significantly, higher taxation encouraged the adoption of evasive strategies to minimize taxes by a host of activities that lacked any redeeming social value.
As for public expenditures, movement of social assistance payments from discretionary to entitlement programs had, in addition to contributing to problems of budgetary control, tended to have adverse effects on incentives to production. As a logical extension of the growth of this category of expenditures, it was implied that, as these payments became durable and came to be an inseparable part of the community's expectations, the possibility of restoring incentives through tax cuts also became too remote to be practicable. As the burdens of inflation increased and as the competitive prospects of domestic industries became dim, governments resorted to the provision of subsidies for private enterprises. Subsidies of this type proved “a certain recipe, not for growth without inflation, but for inflation without growth.”13 Other subsidies intended for households and individuals lacked specificity and tended to treat all income groups alike. More significantly, in the general concern with stabilization, considerations of allocative efficiency, as well as the attack on poverty, were relegated to the background.14
The financing of government budget deficits by printing more money was not followed by an expansion in output, and the feasibility of such a policy was questioned by some economists from the early 1950s. The second approach—financing the budget by borrowing from the public—implied a steady increase in the supply of government bonds. In order to improve their attractiveness for being held on a continuing basis by the public, these bonds were offered at a low price, thus pushing up interest rates. The increased interest rates had the effect of discouraging the issue of private bonds, private investment, and private spending, all of which are interest elastic. In turn, this contributed to a financial “crowding out” of the private sector. Thus, fiscal policy, which in the Keynesian framework would increase incomes through deficit spending and thereby encourage private investment, would, if the financial crowding out is empirically valid, have the opposite effect of reducing private investment. The long-term implications of these fiscal policies were different from the short-term expectations, and this gave rise to a contradiction in Keynesian economics. More important, a view developed that the above-mentioned problems might not arise if the government's policy was merely anticyclical rather than conjunctural, so that deficit was followed by surplus in a reliable averaging process. Associated with this view was the contention that enlarged public sectors reduce individual freedoms. The debilitating effects of governmental policies are not necessarily confined, in this view, to fiscal policies only, but are inherent in the massive growth of governmental regulations on individual activities.
The above limitations of fiscal policy obviously vary from country to country and are dependent, to a large extent, on the actual pattern of financing the budget. Nor should it follow that these limitations are accepted by all. Some consider that, over the years, there has been a growing acceptance of the levels of taxation by the taxpaying public, that the public has tended to consider national debt, not with alarm and apprehension but as a reasonably good monetary instrument for long-term and short-term investments, and that inflationary financing has its purpose. It is not the intention here, however, to enter into a discussion of the relative merits of the opposing viewpoints nor to establish the validity of one over another but merely to illustrate the hiatus that fiscal policy reached by the end of the decade of the 1970s.15 All economists accepted the growth in public expenditure; what some disputed was whether it necessarily implied inadequate use of the resources acquired from the private sector and whether such acquisition had become more destabilizing by fueling inflation by higher taxes and interest rates. The conflicts in Keynesian economics between the short-term and long-term uses of its prescriptions and its overall inability to contain the rising expenditures came to be viewed with concern, and the attraction of this theory suffered serious damage. If the underconsumption theories in the early 1930s and the recognized failures of the market system to provide employment and stability brought greater intervention by government, the failure of the administrative state to stabilize the economy brought back, as will be shown further on, the argument against state intervention and balanced budgets as the only effective remedy for controlling public expenditures. For good or bad, the policy option at the beginning of the decade of the 1980s was viewed as limited to stabilizing the levels of public spending for the time being. This should not, however, be considered, given the diversity in fiscal situations, as a general case against public expenditure as such. Indeed, there are countries and situations where there are clear needs for increasing public investment, for improved provision of collective goods, and greater attention to redistribution programs. Failure to do so could lead to welfare losses. The crucial question then, as it always has been, is how to provide goods and services and how they are to be financed in a manner that assures economic stability, while at the same time retaining the requisite resources in the hands of the community and providing an incentive structure that will promote growth in the economy. The solutions are many, and some have not yet been fully tried.
Two suggestions to remedy the above situation and to provide new directions to fiscal policy are, broadly (1) the approaches of a school of thought that have come to be known as the supply side of economics, and (2) the approaches of pragmatic policymakers. The supply-side school of economics has many interpretations and its limits are still being defined. However, two distinctive schools of thought can be discerned within supply-side economics. Members of the first school have a fundamental philosophy of the state, while those in the second school concentrate their efforts on methods of eliminating the bottlenecks in the economy and of promoting industrial activity. The concern of both schools, however, is that budgetary instability should be avoided and that budgets should be balanced. Balancing of the budget can be done in several ways at many levels. Both contend that, as taxation levels have reached the point of becoming counterproductive, reliefs should be provided, tax levels reduced, and expenditures contained at the reduced level of taxes.
The first school of thought in supply-side economics emphasizes that people must be left free to choose and that the role of government, which has grown to be a giant providing all kinds of services, should be drastically reduced. Provision of educational, health, and community services, or of assistance to the unemployed or backward, are better undertaken through the private sector. The basic assumption in this approach is that government has neither the wisdom nor the competence to provide such services and that the community itself can rake care of its own interests and requirements. The debate concerning the exact role of the public sector has been at the center of political and economic controversies for quite some time. As a budgetary philosophy, it found acceptance in the early 1950s in the United States, by which time the implications of the actual implementation of Keynesian economics began to emerge.16 The practical implementation of this approach is sought through two measures—privatization and constitutional limits on government spending. Privatization, like supply-side economics, has varying connotations in different countries. In essence, however, it implies a once-for-all transfer of some functions from government to the private sector and a heavy reliance on contractual arrangements for providing services. In terms of this approach, the overall governmental responsibility for providing services is accepted, but the medium for providing these services is sought to be changed because the protagonists of this view see the problem primarily as the unwieldy growth of the public sector, which, instead of leading to cost savings through economies of scale, has led to increased unit costs and expenditures. This approach is also based on the belief that any prescription is better than the existing situation.17 It is therefore proposed, with a view to protecting the consumer, that some services may be handed over with government financing to private management, which may perform these services better because its motivation is likely to be different. Moreover, in view of the known costs of contracts and the fact that costs in the private sector tend to be lower because of lighter overhead costs, the rate of growth in public expenditure will effectively be curtailed. An extreme version of this approach, which better reflects a fundamental faith in the market mechanism, is that the interests of the consumer, both in terms of quantity and quality of services, are best served when the government divests itself of its responsibilities and allows the private sector to function in its place. The assumption of the first approach—that no further efficiency is possible in government—may be considered as total lack of faith in administration and as a manifestation of defeatism. Its faith in the private sector's capability for providing the services may be considered naive. However, if this approach is accepted, privatization would impose new responsibilities on public agencies to ensure the quality of services, adding public costs to those already incurred on contracts. As illustrated in Chapter 5, private contractual services have a tendency to escalate in cost and, in some cases, may be more expensive than those of the government. Few services can be so privatized. This approach should perhaps not be seen in terms of rigid alternatives of either the public or private sector substituting for the other but in terms of improving the motivational and management systems in both government and private sectors and in facilitating a review of expenditure priorities. The extreme version, however, is more complex and controversial. Behind its touching faith in the market mechanism is the feeling that the operations of government, beyond the traditional ones of maintaining law and order and particularly in the economic sphere, are all encroachments on individual freedom and conflict with liberty. These philosophical premises can be argued at length but to no conclusion. The final choice is not merely a reflection of an individual predicament but also one's faith or lack of it in the progress made during the last few centuries. In the more technical context of fiscal policy, such divestiture of functions may imply that employment, economic stability, and amelioration of poverty would be left to the market mechanism. This may lead, as John Kenneth Galbraith has demonstrated, to public squalor and to private affluence and to a pattern of a state that is an antithesis to the conventional image of a state.18
The suggestion relating to constitutional limits on spending implies an unusual degree of desperation and lack of faith in the governmental machinery of budgeting and expenditure controls. The main argument in support of such limits is that public pressures are exercised relentlessly by all interest groups and that the only way they can be checked is through constitutional limit that specifies public expenditures as a percentage of GDP, or insists on a balanced budget. It may be argued that constitutional limits are not immutable; the lawmakers that set the limits can also change them. A more significant aspect, however, is that budgets cease to be flexible and may be ineffective in creating economic stability.19 Control of expenditures would shift from within government to external agencies and, if experience is any indication, such a shift would encourage escape mechanisms that would effectively nullify the purpose of the limits. The specification of legally enforceable spending limits is difficult, as the relevant elements are highly variable. Finally, limits are not by any means new, for governments already follow self-imposed limits on the level of the budget deficit or the share of the budget deficit to be financed by borrowing from the public or the banking system; under the proposal, the limits would become legal. It is doubtful whether such legality itself will work any miracles.
Those in the second school of supply-side economics emphasize that, as the major problem (in their view) is not lack of purchasing power but one of constraints caused by the high levels of taxation and regulation, these constraints should be reduced to redress the balance between saving and investment. Tax reduction, it is suggested, would stimulate production and permit more intensive employment of existing capital. It is recognized that tax reduction might not be possible in an inflationary environment, but it is certain that tax reduction will stimulate output so that revenues will indeed rise following a tax cut. Behind this “is a vision of the economy as a coiled spring held down by the weight of government. Remove the weight and the spring will reveal its inherent force.”20 In short, tax reduction is expected to release a miracle of productivity. The relevance of this is dependent on the tax structure and on the assessment of whether indeed it has been counterproductive. It is, however, doubtful whether tax incentives alone have these magical powers and whether equal, if not more, attention is needed on the structural factors, such as the level of technology and changing modes of demand. In its faith, this approach resembles the earlier confidence of the Keynesians in deficit financing as a means of bringing a rapid expansion in output. The reduction in regulation is to be considered in terms of the beneficial impact that it has on the industries and in terms of the relative welfare losses of the community. Regulation presupposes recognition of the harmful effects of conglomerates and other major organizations. Reduction in regulation has the potential effect of making them more powerful, and the very market mechanism that is the cornerstone of supply-side economics may no longer reflect the freedom that is sought.
Supply-side economics has a place in fiscal policy, but it is not the sole answer to current problems. It cannot function alone; it needs to be used in conjunction with demand management approaches. It also takes a long time to be effective because tax reduction does not bring about an instantaneous growth in output, nor does privatization reduce costs. The positive features of supply-side economics consist in a plea for a more detailed and systematic look at the current levels of taxation and expenditures and their composition. The relevance of supply-side economics should preferably be at a disaggregated level in terms of each tax and category of expenditure. If it is so viewed, it may not reach any different conclusions than those reached through the Keynesian framework. The current debate, however, is carried out at a general level, with each school believing in an apocalyptic vision of the future—one foreseeing endless inflation and total loss of freedom, and the other envisaging the disappearance of the state and with this the neglect of the poor. The more mundane problems of fiscal policy need to be seen in terms of the allocative efficiency of resources.
The problems of expenditure growth, however, are real and need to be addressed if fiscal policy is to have relevance in the management of the economy. It is here that the approaches of the pragmatic school of thought offer some positive directions for the conduct of fiscal policy. These approaches recognize that public expenditures rise because of political pressures and the absence of market discipline and competition. They believe in a community that seeks to fulfill its requirements through government. The important objective is not to perform the fiscal functions differently, but rather to perform them better or more efficiently. It is also recognized that the community has an increasing demand for public services while at the same time it resists increases in taxation and other changes. This approach, therefore, seeks to foster a link between services and payments, on the one hand, and a better use of the fiscal instruments, on the other. There are, as noted earlier, no immutable levels of public expenditure that offer stability or inflation growth. Each country has to find its own level by experience. In terms of these pragmatic approaches, governments should aim at achieving a spending level that does not put undue constraint on the conduct of monetary policy nor limit work or investment incentives in the private sector. In achieving this level, fiscal policy should not merely be determined but is also viewed by the public as decisive in reducing the inflationary pressures in the economy. Since major problems of the past have largely arisen from frequent shifts in policy, changes should be minimized in order to provide a degree of stability to fiscal policy in the medium term. Toward this end, the overall levels of taxation and expenditure should be reconsidered, and priorities should be reorganized in the light of the changed economic situation. Tax incentives might be restructured, and in order to facilitate the link with payments, user charges might be introduced in selected areas. Within expenditures, the structure of subsidies might be revised and made more specific. More significantly, in view of the continuing need for commitment of growth, resources might be selectively redeployed and greater emphasis placed on investment expenditures and their efficiency.
The pragmatic approaches aim at a constructive role for fiscal policy that is generally applicable to both industrial and developing countries. Conversion of generalities into practicalities is, however, the task of fiscal machinery, which is the subject of the following chapters.
Government action can be considered to be purely a fiscal policy matter only when the effect of borrowing is neutral in terms of the availability of money to the private sector. Pure fiscal policy is, however, rare, because any change in revenues and expenditures involves changes in the financing of the budget surplus or deficit and, hence, always has an interface with monetary policy. Management of the debt—particularly, the composition of the instruments, the timing of their issue, and their duration—are aspects more closely associated with monetary policy.
C. F. Bastable (1903), p. 611.
A. J. V. Durell (1917), p. 242.
Robert S. McNamara, former President of the World Bank, noted in 1972 in his opening address to the Boards of Governors of the World Bank and the International Monetary Fund, “[w]hen the highly privileged are few and the desperately poor are many—and when the gap between them is worsening rather than improving—it is only a question of time before a decisive choice must be made between the political costs of reform and the political risks of rebellion.” He also provided a graphic description of poverty in his opening address to the same gathering in 1980. “Absolute poverty …,” he stated, “is a condition of life so limited by malnutrition, illiteracy, disease, high infant mortality, and low life expectancy as to be beneath any rational definition of human decency.” Poverty is not only a feature of developing countries, it is also found in industrial countries. Differences are in the nature, extent, and profile of poverty.
See Naomi Caiden and Aaron Wildavsky (1974). In terms of the authors' approach, countries that have a per capita income of less than $900 per annum, low levels of resource mobilization, low accountability for expenditures, and weak administrative systems are to be considered as poor. Empirical verification of these criteria reveals that there are at least 66 countries with less than the specified per capita levels but not all of them are poor in the budgetary sense for at least 11 of them had budget surpluses for a few years—some of them being oil producing countries. Even from the resource mobilization point of view, some of them have tax ratios of more than 20 percent of GNP. It appears that equating material poverty with poverty in budget systems is not warranted. Economic and financial constraints operate in all countries, including the rich ones.
Data shown in Table 2 do not fully capture this factor, as education and health are generally within the jurisdiction of state and local governments, whose expenditures are not included here.
Subsidies and current transfers shown in Table 2 comprise a broad category that includes several types of transfers, including those to enterprises and other levels of government. The statements on social security are based on other data not shown here.
For such surveys, see Organization for Economic Cooperation and Development (1978); Thomas E. Borcherding (1977); Richard M., Bird (1979); and Morris Beck (1979), pp. 313–56. These surveys deal only with the growth of public expenditure in industrial countries.
The futility of the short-term efforts was eloquently expressed by the British Prime Minister James Callaghan in 1976 in these terms: “We used to think that you could just spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, insofar as it ever did exist, it worked by injecting inflation into the economy. And each time that happened the average level of unemployment has risen. Higher inflation, followed by higher unemployment. That is the history of the last twenty years,” address to the Annual Labour Party Conference, 1976.
For some typical views in this regard, see James Buchanan and Richard E. Wagner (1978), pp. 1–8; Richard E. Wagner and Robert D. Tollison (1980). In respect of the debate in the United Kingdom, see P. M. Jackson (1980), pp. 66–82.
Robert S. McNamara described the situation thus, “The argument will be that poverty is a long-term problem and that the current account deficits are a short-term emergency: that poverty can wait, but that deficits can't.” He added, “Sustaining the attack on poverty is not an economic luxury—something affordable when times are easy, and superfluous when times become troublesome,” opening address to the Board of Governors of the World Bank and the International Monetary Fund, September 1980.
The institutional implications of these issues for budgeting are considered in the following chapters.
President Eisenhower stated as his budget objective in 1954 the following: “By using necessity—rather than mere desirability—as the test of our expenditure we will reduce the share of the national income which is spent by the government…. government must play a vital role in maintaining economic growth and stability. But I believe that our development since the early days of the republic has been based on the fact that we left a great share of our national income to be used by a provident people with a will to venture,” Budget Message to the Congress.
See William A. Niskanen, Jr. (1971), pp. 200–210.
Social Democrats who forged the expansion of the state believe that reliance on market mechanism provides no acceptable social or political theory.
Those who argue for constitutional limits on spending believe that “[f]iscal policy is simply not a tool for creating economic stability.” This denial of the role of fiscal policy is not, however, warranted by the analysis of this approach. See Wagner and Tollison (1980), p. 17.
Robert L. Heilbroner (1981), p. 37.