1 Fiscal Policy for Growth and Stability in Developing Countries: Selected Issues

A. Premchand
Published Date:
June 1990
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Over the past decade two major intellectual developments (some would call them revolutions) have had a major impact on how economists and policymakers think about the way policies affect economies. The first of these revolutions is associated with a growing body of literature that goes under the name of “public choice.” In 1986 James Buchanan received a Nobel Prize in economics for his seminal contributions to this literature. The second is the less unified, but highly influential, thinking that goes under the name of supply-side economics. Supply-side economics had its major expression in the United States under the Reagan Administration. Its influence has progressively spread to other countries, both developed and developing.

Major recent changes in tax reform, in privatization, and in deregulation have been facilitated, and perhaps even promoted, by these two major developments. The present paper discusses some of the implications of these developments for fiscal policy in developing countries. It does this in part by focusing on some of the basic but implicit assumptions that guided fiscal policies in the past and that still guide many current policies. The two developments mentioned above have had powerful implications for fiscal policy. In general they have tended to reduce the desired role of the government in the economy.


The term “fiscal policy” applies to the use of public finance instruments to influence the working of the economic system to maximize economic welfare. However, this is too vague a concept to be the focus of specific policy measures. For this reason, policymakers concentrate on more specific objectives, such as reduction of the rate of inflation, acceleration of the rate of growth, and redistribution of income. The activities of the public finance authorities are generally classified under four broad functions: allocation of resources, redistribution of income, stabilization of the economy, and the promotion of economic growth.

The allocation of resources is the function that has been emphasized for the longest period of time. At least since Adam Smith wrote the Wealth of Nations in 1776 it has been recognized by economists that an organized society requires certain goods and services whose technical characteristics (indivisibility, jointness of production, etc.) make their provision by the private sector unprofitable. These so-called public goods include defense, law and order, justice, basic education, and provision of roads.

Early in this century the need to redistribute income began to attract the attention of economists and governments. It was realized that the distribution of income that would result from the working of the economy might not be the one desired by society. Governments began to worry about the disabled, the old, the very young, the unemployed, and other particular groups that, without government assistance, might end up with incomes below some poverty line. In recent decades, governments have taken upon themselves the responsibility of supporting the consumption of various groups and, as a consequence, public spending for transfer payments has grown at a very fast pace. The concern for redistribution is largely a product of this century. Today some societies pay more attention to the distribution of income than others and are more willing to sacrifice other objectives (such as efficiency) to pursue the objective of a better distribution of income.

The third function, stabilization, is even more recent than redistribution as a legitimate objective of the government. The idea that the government could and should explicitly try to stabilize the level of aggregate demand through its own public finance activities originated with the writing of John Maynard Keynes in the 1930s. It implies that government revenue and expenditure should be used as instruments to reduce cyclical variations in economic activity.

In industrial countries the role of the public finances encompasses the foregoing, since growth is generally expected to follow automatically from the proper pursuit of those three functions. However, in developing countries, with income levels much below those of the industrial countries, it has often been argued that growth should be an explicit and separate objective of policy. It is argued that the government cannot passively accept the rate of growth that automatically results from the activities of the private sector but should actively pursue policies aimed at accelerating that rate.

The role of the government can be evaluated from two different angles: One focuses on what the government should do to promote the rate of growth of the economy; the other focuses on what the government should not do to avoid becoming itself an obstacle to growth. The first aspect emphasizes the potential or theoretical role of the government in mobilizing resources, in raising investment, in creating social and economic infrastructure, and so forth. The second, more passive, and more realistic aspect emphasizes the limitations of that role and the risk that when the government attempts to do too much it may create obstacles and difficulties. This second aspect is influenced by recent writing on “public choice” and on supply-side economics. It is an aspect that emphasizes the need to pursue policies that are more market oriented and that do not replace the judgment of the market with that of civil servants except where this replacement is justified by the presence of public goods and exceptional externalities. It is also an aspect that brings greater realism in economic policy.

Until the recent emphasis on supply-side economics, the governments of the developing countries were advised: (a) to increase tax revenue to mobilize more resources; (b) to increase public investment; (c) to promote private capital accumulation through investment incentives; (d) to take over many economic activities, especially through the creation of public enterprises, thus providing capital and managerial skills assumed to be lacking in the private sector. With increasing frequency governments are now (a) reducing tax-created disincentives; (b) privatizing public enterprises; and (c) reducing those regulations and policies that give much discretion to some public employees, such as those, for example, that grant import permits, tax incentives, and so forth. The recent tax reforms reflect a realization that the government should play a more neutral role in the economy.


In their pursuit of economic objectives, the authorities rely on a variety of policy instruments which, at least in theory, can be manipulated to achieve particular social objectives. These instruments can be classified into broad categories or can be identified in terms of the specific characteristics of each category. For the broad categories there are the revenue and expenditure instruments. Among the revenue instruments, the most important role is played by taxes; however, governments rely also on fees, on the prices of public utilities, and on sales of assets. In addition to providing revenue, each tax can also be used to achieve particular goals. For example, import duties can be used to influence the balance of payments; excise taxes can be used to influence consumption patterns, and so on.

Next, governments can finance the part of their expenditure not covered by ordinary revenues (taxes and fees) through foreign borrowing, borrowing from domestic nonbanking sources, and borrowing from the domestic banking system. Depending on their particular situations and on the objectives they wish to pursue, countries rely more on some of these sources than on others.

An important classification for expenditures is that between real expenditures and transfers. Especially in industrial countries, much of the growth in public spending over the years has occurred in the form of transfers. Another classification considered important by some economists is that between capital and current expenditure, on the presumption that capital expenditure contributes to growth while current expenditure does not.

The traditional theory of public finance assumes that the government can manipulate these instruments, both those on the revenue side and those on the expenditure or financing side, to achieve particular objectives. This theory, which goes back to the work of both Keynes and Tinbergen, is based on a series of strong but unstated assumptions that, in all countries but especially in developing countries, are often not realistic. As already mentioned, public choice and supply-side economics present major implicit challenges to these assumptions.

The first assumption is the one that views the public sector as a monolithic entity. It is assumed that within the public sector there is a focus of decision making that controls all public finance decisions in the country. The reality is obviously different. The public sector is not made up of one entity but of many, and, in some cases, literally hundreds of separate entities. Some of these entities have enough political power and independence that they can go on “doing their own thing” even when contrasting signals are being sent by the central financial authorities, such as the treasury or ministry of finance. This is particularly true for some large public enterprises, for local governments, and even for some ministries and social security institutions. At times these entities have objectives or perceived responsibilities that in some ways diverge from those of the ministry of finance. They may also have enough political power to ignore, or at least to interpret in their own way, the instructions that they receive from the ministry of finance or the treasury. When this is so, the possibility of pursuing a rational and well-coordinated public finance policy to promote growth and stability is undoubtedly made much more difficult.

The second strong assumption made by the theory of public finance is that there is a clear and well-articulated public interest that is pursued by the individuals who make policy decisions, who interpret them, or carry them out. Unfortunately, the reality may sometimes be different. Policymakers, as well as the civil servants who must implement the decisions made at the highest level of government, may have their own interests. These interests may in part diverge from the public interests pursued through the chosen economic policy. This divergence is facilitated when, as is often true, the public interest is not well articulated. These private interests may originate from many sources: political or class affiliation, regional, racial, or tribal backgrounds, friendship or family ties, etc. When the divergence between the general interest and the private interests of those who must carry out the formal policy decision is substantial, the results of policies may differ from those anticipated. A common example of this divergence is provided by tax reforms that in some cases may not lead to major change in tax collection or tax incidence because the tax administration may de facto ignore the legislated changes.

The third assumption relates to the assumed superiority of information available to the government and to the presumed managerial superiority of public sector employees. Some of the original justification for expanding the role of the public sector was founded upon this assumption. The government was assumed to have access to information not available to the private sector. Furthermore, it was assumed that the government could provide managerial skills lacking in the private sector. Even if this assumption had some validity in earlier years, it is less valid today; first, because the information revolution has made much information available to everyone; and second, because in several countries (for reasons elaborated later), there has been a relative deterioration in the average quality of those who work in the public sector.

The fourth assumption is that the instruments of economic policy are highly controllable and that decisions can be easily reversed. In other words, the government will be able to increase or decrease particular taxes and particular types of spending as required by the evolving circumstances in the economy. However, some instruments are far more controllable than others, and some decisions can be made more easily when they require changes in some variables in one direction than in the opposite direction. For example, revenues from particular taxes may be influenced by factors (such as inflation, changes in world prices) that are beyond the immediate control of the government. Furthermore, it is much more difficult to reduce taxes or increase spending than to do the opposite.

In the traditional theory of public finance, it is assumed that the instruments used to pursue economic objectives will be public finance or monetary instruments. In practice, governments often pursue their objectives through regulations. To some extent, regulations can replace public finance instruments. For example, the consumption of an imported product can be subsidized either through the budget or by letting the exchange rate become overvalued. In many developing countries overvalued exchange rates conceal a lot of disguised redistributional activities on the part of the government. The production of a given product can be subsidized either directly through the budget or by restricting the importation of competing products.

Regulations have far less transparency than traditional public finance instruments and may involve very high but hidden efficiency costs. They are often justified in terms of some apparently worthwhile objective (protecting employment) and seem to be costless. Furthermore, they have a low direct cost of introduction, since they can often be introduced without formal legislative enactment. There has, thus, been a tendency in developing countries to rely excessively on them. The net result is a situation where the economy becomes overregulated and highly inefficient. Moreover, economic policy appears haphazard and without a clear sense of direction. One of the merits of public choice and supply-side literature has been to focus on these aspects of public policies that had received relatively little attention in the past. This literature has called attention to the efficiency costs of regulations and to the likely abuses that often accompany them.


In recent years a tendency has arisen to advise countries to reduce the size of the public sector. But how does one measure the size of the public sector? Traditionally, the focus has been on tax levels. Studies of tax levels tried to develop norms that would indicate the tax level that a country was likely to have, given its level of economic development, or (in the more normative approaches) the tax level that it should have. However, the tax level is not a good measure of the size of the public sector and its impact on the economy because it may not be closely related to the level of public spending and because it does not reflect the impact of the public sector through its regulatory instruments.

A country with a fiscal deficit has a level of spending that exceeds the level of taxation (including fees and other ordinary revenue); and public spending is probably a better measure of the absorption of resources by the public sector than tax revenue. Regulations on economic activities proliferate in these countries, and the impact of these regulations is, as mentioned above, often similar to that of traditional public finance instruments. Regulations are not quantifiable, so that it is impossible to compare quantitatively the impact of the public sector of different countries when they have different regulations. When regulations are taken into account, the conclusion is likely to be that in many developing countries the public sector may be far more pervasive in its impact than in industrial countries, even though the latter have much higher levels of taxation or public spending than the developing countries. However, if regulations can be easily circumvented through bribes, they may have more of a redistributional effect than an allocative effect.

For developing countries the ratio of taxes to gross domestic product (GDP) averages about 18 percent. There is some relationship between that ratio and the level of economic development, since as countries become richer the ratio of taxes to GDP normally rises. Tax levels in developing countries are also influenced: (a) by the level of public spending because, in spite of deficit financing, taxes still remain the major source of financing public expenditure; (b) by the structure of the economy, because some economic activities are easier to tax than others; (c) by social factors reflecting the attitude of the citizens vis-à-vis the government; and (d) by factors such as urbanization, literacy rate, and monetization of the economy. They are also influenced (e) by the structure of the tax system itself.

As the tax level goes up as a share of GDP, the number of taxes used by countries generally decreases. In other words, countries come to rely on a few productive taxes, rather than on many unproductive ones. As countries develop, the importance of foreign trade taxes falls, since governments recognize that these taxes distort the allocation of resources and retard the rate of growth of the country.

A modern tax system will rely to a considerable extent on general sales taxes and on income taxes. In recent years, economists have favored taxes on consumption more than taxes on income. A general sales tax applied at just one rate (or with very few rates) is preferable to sales taxes applied with many rates. Some studies have shown that the benefits, in terms of equity, achieved through a multiplicity of rates are small while the administrative costs of using multiple rates are considerable. When a country wants to single out particular items for heavier taxation (such as tobacco products, spirits, petroleum products, and some luxury items), it is preferable to do it through excises. The attitude vis-à-vis the structure of income taxes has also changed in recent years. In the past these taxes were normally applied with high marginal tax rates. The current thinking is that high marginal tax rates have serious disincentive effects and, by providing a strong stimulus to evasion, have also serious equity implications. Also the attitude toward tax incentives has changed. Many economists now prefer a tax system with lower tax rates, applied without exceptions, to one with high tax rates accompanied by tax incentive for some activities.

In conclusion, the structure of taxation most favorable to the growth of a country is one that relies on taxes with broad bases and low and relatively undifferentiated rates. A general sales tax, often of a value-added type, and a broad-based income tax should be the keystones of modern tax systems. These two taxes should be accompanied by excise taxes on traditional sources such as tobacco products, spirits, petroleum products, and on some luxury items. Depending on the need for large revenues, some countries may have to impose taxes on imports. Taxes on imports should be levied on all imports at low and relatively undifferentiated rates. High import duties should not be used to discourage the consumption of luxury products, since that may create an incentive to the domestic production of those products. Luxury consumption can be discouraged more efficiently with excises. Nonetheless, it is preferable to have high import duties than to have quotas and other quantitative restrictions. Taxes on property remain an important, though underutilized, element of tax systems. They are important for the financing of local services. However, considerable administrative attention is required to keep the assessments of properties close to their actual values. Unfortunately, these taxes do not fare well in countries with inflation, and they have been losing importance in the tax systems of many countries.

Tax systems should reflect other important characteristics. They should be simple, since a complicated tax system can rarely be efficient and fair. Complications encourage tax evasion and tax avoidance, create a perception of unfairness, increase investors’ uncertainty about the tax system’s implications and effects on planned future activities, and increase the discretion of tax administrators. Too much discretion on the part of tax inspectors is likely to lead to corruption. A tax system should also be transparent in the sense that it should provide a clear picture of its incidence. A tax system that relies on general sales taxes and on broad-based income taxes would normally exempt the very poor from taxation, as people with very low incomes rarely pay income taxes and much of what they consume is generally exempt from consumption taxes (for example, subsistence production). A tax system that depends on many taxes and on many rates is neither simple, nor transparent, nor likely to exempt the poorest individuals from taxation.


In recent decades, the ratio of government expenditure to GDP has increased in most countries. In many countries its present level cannot be financed by ordinary sources of revenue. As a consequence, many governments have been compelled to borrow heavily from foreign sources, thus accumulating a large stock of foreign debt, or from domestic sources, thus accumulating domestic debt or generating inflation and other pressures on the economy. The growth of public spending was justified on grounds that the government must promote economic growth, sustain economic activity, and bring about a better income distribution. The view was that, without this large growth in spending, economies would be anemic and unstable and the distribution of income would be less even. Yet those with an interest in economic history will be aware that in many countries income distribution has not improved much over long periods; economies have not become more stable because of governmental intervention; and the rate of growth has not accelerated because of the larger involvement of the government.

The period between 1870 and 1913 is considered by economic historians as one of the most dynamic periods for the economies of the modern world. In that period the rate of growth of countries was normally very high, and much modern infrastructure such as railroads, roads, and schools was built, especially in industrial countries. Yet the level of public spending in the industrial countries was remarkably low. For example, in France it was only about 10 percent of national income, and similar percentages are found for the other countries. These percentages raise doubts about the essentiality of a large public expenditure in promoting economic growth.

Public spending is needed to create the social and economic infrastructure that allows an economy to grow and achieve a high level of income. An economy without good railroad facilities, good roads, good schools, adequate health care, and many other institutions (a police force and a judicial system) is unlikely to become a modern economy. But special care must be taken to ensure that the spending for this infrastructure is carried out efficiently and allocated to the most productive uses. In many developing countries, there has been a tendency to favor new projects at the cost of the existing infrastructure. New roads have been built while the existing ones were allowed to deteriorate; new irrigation schemes have been created while the existing ones were not properly maintained; new schools were constructed while the general level of education was allowed to fall because of lack of textbooks, good teachers, and other facilities. Usually, more attention has been paid to carrying out new investment projects than to maintaining the existing infrastructure in good working order or to utilizing it at full capacity. Often, new projects that would generate low rates of return were financed by foreign borrowing obtained at high cost.

The gap between the rate of return on investments and the costs of servicing the capital borrowed to finance them has created difficulties for many developing countries. A general, obvious, and simple rule, which unfortunately is often forgotten, is that no public spending financed by borrowing should be carried out unless the expected rate of return on it at least equals, and is preferably higher than, the cost of obtaining the resources. This rule is especially relevant when spending is financed with borrowed external funds.

Before new projects are approved, existing infrastructure should be put into good working condition. Expenditures for operation and maintenance should be given priority, even if it means reducing the level of investment. Building a new road has no point if existing roads are allowed to deteriorate for lack of repair. The same applies to other sectors.

An area that deserves special mention in discussing public spending is public sector employment. In many countries public sector employment has been expanded beyond the level needed largely by reducing public sector real wages. In these circumstances the quality of the civil service deteriorates, leading to an even larger decline in its productivity.

When real wages fall below some level imposed by comparability with the private sector, some unhealthy developments for the economy take place. Low real wages, together with politically motivated hiring, make employees feel that the salaries they receive are almost an entitlement or a pension. Job shirking becomes common. Public employees begin to get second jobs and to allocate more of their energy to the unofficial jobs. Their honesty is also affected. Corruption finds a fertile ground in situations where real wages have become too low. This problem is especially serious in tax administration, where low wages are likely to increase the receptiveness of tax inspectors to bribes, but it is not limited to that sector.

The reduction of real wages is often accompanied by a flattening of the salary scale. In some developing countries the difference between the lowest salaries and the highest salaries in government jobs has been reduced to a much greater extent than in the private sector. As real salaries in the public sector are sharply reduced—especially for those who are charged with making important decisions—an exodus of the most able and best trained is likely, since they can most easily get jobs in the private sector. Except for highly motivated individuals, or for some who may take advantage of their positions to generate additional incomes, those left in government tend to be those with less marketable skills.

The wage bill should be reduced by reducing numbers of employees and not real wages unless the latter have become high because of union power or other factors, compared with the income level of the country or the wage level in the private sector. In this process the structure of wages in the public sector must receive close attention. When the general level of wages, especially for key personnel, falls much below the level in the private sector, the quality of public sector activity inevitably deteriorates, bringing with it serious costs to the economy. This is an area that, in spite of its importance, has attracted little attention. The ultimate objective should be a public sector made up of a small, efficient, and relatively well-paid civil service.

One of the modern characteristics of countries is the large share of subsidies and transfers in the total budget. One reason why the level of spending in national income was so much lower at the beginning of the century was precisely because these subsidies and transfers were almost nonexistent. Selective transfers to groups that, because of handicaps, advanced age, or particular situations, are so poor that they cannot take care of themselves are obviously fully justified. Unfortunately, in modern economies transfers are so generalized that they cannot truly be defended as an instrument for improving the income distribution. The moment the government begins to broaden its involvement in sustaining certain prices or in sustaining certain incomes, it opens itself to political pressures from groups that do not need that assistance but that can always make a case for getting it.

The basic message that comes out of this discussion is one that emphasizes the need to reassess many of the activities of the government and to ask specifically the reason why the government is involved in certain activities.


A country undergoing an economic crisis, associated either with inflation or with large disequilibria in the balance of payments, is unlikely to sustain a good rate of growth. Developing countries are more prone to economic instability than industrial countries, since they are exposed to a variety of external shocks that affect their economic performance. These shocks may be associated with changes in export earnings, since many of these countries rely heavily on the export of one or more commodities for their foreign exchange earnings. They may be due to (a) changes in the prices of major imports (oil); (b) changes in the cost of foreign borrowing, as happened in the early 1980s when real interest rates rose sharply; (c) changes in the availability of foreign credit, as happened after the debt crisis of the summer of 1982 when banks became much more reluctant to lend; and (d) changes in the level of foreign grants.

These external shocks do not affect just the incomes of the countries, but also their fiscal accounts, because of the close link between the budget and the foreign sector. This link depends on (a) the proportion of foreign trade taxes in total revenue; (b) the proportion of domestic sales taxes collected from imports; (c) the reliance on corporate income taxes collected from companies that export mineral products; (d) the reliance on the part of the public sector on foreign borrowing or foreign grants; (e) the proportion of foreign debt that is public; and (f) the attempt to insulate some domestic prices from movements in world prices.

Foreign trade taxes account for about one third of total tax revenues in developing countries. If one adds to this the share of corporate income taxes collected from mineral exports, and the share of taxes on goods and services levied on imports, it appears that about 50 percent of the total tax revenue of developing countries may be directly related to the foreign sector.

Ideally, a government with fluctuating revenue should base its expenditure on the average (or trend) level of taxation and other current revenue over time. This relationship implies that the country should run a budgetary surplus in good years and a deficit in periods when exports are lagging behind their trend level, or when other negative factors predominate. Thus the government would accumulate assets (or reduce the debt) in good periods and run them down (or increase its debt) in others. To some extent some of the oil exporting countries have done this. Kuwait, for example, accumulated large surpluses in the period after 1974, when the price of oil was very high, and has since then been using these surpluses.

In the majority of developing countries, however, periods of boom have often led to sharp increases in government spending. In some countries the increase in spending even exceeded the much higher revenues that had become available during the commodity boom. When the boom came to an end, they had expenditure commitments that could not be sustained by the current or even the long-term level of revenues, and that could not be reduced quickly. To make matters worse, the end of the boom in commodity prices was accompanied in the 1980s by sharply higher interest rates and limited availability of foreign loans. The foreign financing of the deficit thus became more difficult and more expensive.

Fiscal deficits can be financed by domestic noninflationary sources, domestic inflationary sources, and foreign sources. Inflationary financing of the fiscal deficit distorts domestic prices relative to foreign prices, distorts tax revenue, and brings about many other complications. It is thus difficult to accept the notion that these costs do not overwhelm the benefits from the spending that is financed by it. Domestic noninflationary financing is normally quite limited in developing countries because of the size of their capital markets and because of the generally low saving rates by households. In addition, this type of financing, like inflationary financing, tends to crowd out private sector activities, although it is less likely to have inflationary consequences. This leaves foreign financing with all its complications and problems. Many developing countries are today facing the serious consequences of excessive reliance on this source of finance. The connection between financing of the fiscal deficit and the external sector often forms the basis for the involvement of Fund programs with the fiscal accounts of the country.

The implication of this discussion is that, over the longer run, a fiscal policy that is consistent with growth and stability will require bringing public spending into line with the average level of revenue expected over time. For a variety of reasons—some administrative, some technical, some political—there is in most countries some limit to the tax level and to the other sources of ordinary revenue. Thus it is often unrealistic to believe that unsustainable fiscal deficits can be eliminated solely or mostly by increasing taxes. A permanent reduction in the fiscal deficit must often come mainly from a reduction in the level of public spending, although the option of raising nondistortionary tax revenue should always be fully exploited. When public spending is reduced for stabilization reasons, the reduction in expenditure must follow clear criteria of efficiency. Cuts that follow the line of least resistance are often the wrong ones, although unfortunately they are often the first to be made.

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