Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Miguel Urrutia

Manager, Economic and Social Development Department

Inter-American Development Bank

The paper by Professor D. Gale Johnson attempts to find some generalizations that apply to the problems of adjustment in the agricultural sector of most developing countries. Although some common problems are indeed identified, the solutions are of such a general nature that they might only, with difficulty, be translated into concrete programs of actions and quantifiable targets that might trigger the disbursement of agricultural sector loans by the multilateral financial institutions.

It is one thing to say that most agricultural sectors are discriminated against, and quite another to design specific adjustment policies. Effective devaluation may not lead, in the short run, to greater agricultural exports in a country producing commodities that have high protection in the industrial nations. Special measures may have to be taken to facilitate export diversification, in addition to the more common adjustment measures.

The first obvious conclusion is, then, that there cannot be a general program of agricultural adjustment. In what follows I would like to bring out some specific questions that may require further discussion.

First, Professor Johnson acknowledges that international market prices for farm products are significantly distorted. If that is the case, should distorted international prices determine national policies? Probably not. In the present international trading system, the exports of meat of the United Kingdom have been increasing, and those of Argentina decreasing. Something is seriously wrong with the incentive systems. Should Brazil set internal sugar prices at the international price, which clearly does not cover the costs of the most efficient producers? Again, the answer is probably no. Most nations with limited foreign exchange will have to manage agricultural imports, taking into account the undesirable price distortions of agricultural products in the international market and compensating for them through specific import and export policies.

Second, agricultural sectoral adjustment cannot be looked at in isolation. Such adjustment must be inserted within the general macroeconomic adjustment taking place in most developing economies. In many economies, exchange rates are being adjusted and fiscal deficits reduced. The exchange rate adjustments will produce an export supply response in agriculture. Will industrial countries absorb those exports? The balance of payment surplus countries, Germany and Japan, certainly will not accept much larger imports of agricultural goods. Are agricultural adjustment programs taking this into account? There may be possibilities for increased south-south trade. Mechanisms for increasing such trade might be necessary complements to the recommended adjustments in relative prices being carried out in most developing countries at present. Financing mechanisms for such south-south trade could increase the viability of agricultural adjustment programs that favor the production of exportables.

Third, the paper rightly emphasizes the bad record of marketing boards. Nevertheless, these institutions were originally established to try to integrate farmers into the market. Unfortunately, many marketing boards developed into monsters that exploited these farmers, but their excess should not blind us to the role the state can have in the promotion and growth of markets. There is a need to create institutions that facilitate the functioning of markets in rural areas. Markets sometimes do not develop without some support. Many agricultural production projects have failed owing to imperfections of distribution channels. In developing and industrialized countries, cooperatives and producer associations have integrated many small farmers into national markets. Investment in the infrastructure needed for the growth of markets is a valid development activity. Markets are also fragile. Sudden import or price liberalization may in fact destroy fledging markets. Financial liberalization may fatally weaken some financial institutions that in fact have served poor farmers, unless special measures are taken to avoid such an outcome.

Fourth, macroeconomic adjustment is in all cases making it difficult to maintain food subsidies that affect the government budget. It is likely that better targeting can contribute to fiscal health, but some food entitlements must be assured to the poor. Given the combination of barriers to exports of agricultural goods and the existence of malnutrition in most developing countries, there is a need to design food entitlement systems that will, at the same time, promote agricultural production by increasing demand and diminish poverty. The macroeconomic adjustment programs should contemplate such programs.

In summary, I do not agree with Professor Johnson when he says that it is not too difficult to specify what constitutes appropriate structural policies for agriculture. It is quite difficult. The problem must be looked at in the general framework of the macroeconomic program for an individual country, and the policies must be adapted to the particular agricultural production structure.

Professor Johnson states that farm people should not be discriminated against in the provision of public services and infrastructure, such as transport, communication, and cultural facilities. This is true, but it ignores the fact that the provision of services is more expensive in rural areas, particularly when settlement is dispersed. Given the higher costs, it appears more efficient to provide such services first in urban areas, and that may be rational. In Latin America, in areas of dispersed settlement, rural investments are very expensive and may have to be postponed if adjustment programs create serious budget constraints.

On the other hand, it is clear that urban subsidies through user charges are probably unwarranted and excessively encourage rapid urbanization. The whole issue of user charges and income transfers to the poor, particularly those in rural areas through user charges, is a most interesting policy area in a world in fiscal crisis.

Unfortunately, then, the multilateral banks will not be able to use a general formula for agricultural adjustment. The design of agricultural adjustment programs will have to emerge from a complete analysis of each economy and the specific characteristics of each agricultural sector.

Many lessons have been learned, as Professor Johnson well points out. It is hard to justify subsidies for modern inputs or price controls that exploit poor farmers. There are also few convincing arguments justifying subsidized interest rates on loans to small farmers. On the contrary, any agricultural adjustment policy should contemplate the strengthening of credit institutions that serve these farmers, and subsidized interest rates never strengthen such institutions.

But, except for these very general policy recommendations, the design of an agricultural adjustment policy will require much analysis by the country authorities, and much technical assistance and understanding from the international community.

G. Edward Schuh

Director, Department of Agriculture and Rural Development

World Bank

Gale Johnson (in his paper Agricultural Structural Policies) has given us an excellent discussion of the nature of structural adjustments faced by agriculture in economies experiencing economic growth, of the way policies designed to deal with these adjustments often go astray, and of the kinds of policies needed to facilitate structural adjustment. At the same time he focused on the way that agriculture is often plundered to meet misguided policy goals.

Professor Johnson makes four points that I would like to single out for emphasis because they are not generally recognized or given sufficient attention in discussions of agricultural sector policy.

First, as an economy grows from low levels of per capita income, the relative importance of agriculture must and will decline. This means that labor needs to shift from farm to nonfarm employment and that eventually the agricultural labor force declines in absolute terms.

Second, governments universally neglect to provide adequate infrastructure and public services for the rural sector, while at the same time they underinvest in the education and schooling of their rural population. They do this while they simultaneously provide a wide variety of subsidies to their urban population.

Third, the failure to have adequate adjustment policies as development proceeds eventually leads to highly distortionary agricultural policies, but this tends to occur only at fairly advanced stages of development.

Fourth, output growth is not the most important goal of sectoral policy; obtaining efficient output growth and dealing with the wide disparity in per capita incomes between the farm and nonfarm sectors should generally receive higher priority than they do.

I would like to build on Professor Johnson’s main analysis by addressing four points.

The Rural-Urban Labor Market, the Migratory Process, and the Inter-Sectoral Income Differential

Professor Johnson fails to address a number of points in his discussion of the persistent need for sectoral reallocation of labor from agriculture to the nonfarm sectors. These are important in designing policies to facilitate the needed adjustment, so I would like to fill in the gaps.

First, the sectoral shift of labor from agriculture to nonfarm employment typically requires the geographic dislocation of labor as well, a phenomenon that is not nearly so important in intersectoral shifts of labor among nonfarm sectors of the economy. This makes the costs to the migrant, both pecuniary and nonpecuniary, a great deal larger and helps explain why the agriculture-to-nonagriculture adjustment process is so difficult and why rural-urban sectoral income differentials often grow so large.

Second, we know the process of geographic migration is highly selective. Those who migrate tend to be the more highly educated, those with more skills, the young and vigorous, and the risk takers and entrepreneurs. That means that the process of migration from agriculture and rural areas drains away the very human capital that could help agriculture and the rural sector to be more productive. This human capital is often financed with local resources and taxes and is in effect given to the higher-income urban sector as a gift. This further exacerbates the consequences of the tendency of governments to underinvest in their rural people in the first place, which Professor Johnson correctly calls to our attention. This explains in large part why problems of regional poverty, such as in the northeast of Brazil, the south of Italy and the United States, and certain parts of Mexico, persist for so long. In effect the migratory process involves significant negative externalities.

Third, this problem can be alleviated by decentralizing the process of industrialization, thus taking employment to the labor force rather than the reverse. More emphasis on strengthening rural infrastructure and public services in rural areas, which Professor Johnson emphasizes, would help facilitate this process, as would raising the level of educational attainment and training among the rural population to levels of the nonfarm sector.

Fourth, investing in the education and training of rural people not only helps narrow directly the income differential between the farm and nonfarm sectors but facilitates the labor adjustment process as well. Education raises the earnings of labor in agriculture by being highly complementary to the introduction and diffusion of new technology in the sector. It also has been found to facilitate the process of labor migration. Hence, investment in the education and schooling of the rural population is a powerful sectoral adjustment policy.

Fifth, fostering migration out of agriculture can also be a powerful growth policy. The large sectoral differentials in per capita incomes between the farm and nonfarm sector mean that the reallocation of labor can contribute importantly to a more rapid rate of economic growth, since labor is taken from low-productive, low-income employment to high-productive, high-income employment.

The So-Called Diversification Problem

The successful introduction and widespread diffusion of high-yielding varieties of rice in south and southeast Asia have given rise to what is widely referred to as a diversification problem. Although the solution to this problem is generally sought in terms of diversification within agriculture, the problem is inherently a problem of diversification out of agriculture and hence is a classic sectoral adjustment problem. Moreover, such diversification as there is within agriculture will probably take place by means of regional and inter-farm specialization, not by intra-farm diversification.

Rice production is a labor-intensive commodity and, when produced under irrigated conditions, involves significant externalities. As farmers shift out of this activity, the opportunities in other labor-intensive commodities, such as fruits, vegetables, and livestock, are fairly limited. Hence, they will eventually be forced to shift into commodities that are of less value and less labor intensive. This will require the enlargement of farms so as to provide incomes comparable with those in the nonfarm sector, and the shift of labor out of the sector. Considerable upward pressure in the land market will be generated in the process, but this will depend on how rapidly labor adjusts. This structural adjustment problem is likely to be increasingly important in the decade ahead, especially in Asia, and one that policymakers will need to deal with successfully if they want to realize the full benefits of the new production technology.

Wide Swings in Exchange Rates Give Rise to Special Adjustment Problems

In today’s configuration of the international economy we are experiencing wide and sustained swings in the value of national currencies, induced in large part by large international flows of capital. Given that the exchange rate system is one of bloc floating, the effects of these realignments in exchange rates extend far beyond the country whose currency is changing in value. Such realignments bring about the need for sectoral reallocations of resources, especially of labor. To date this problem is seldom recognized as the significant adjustment problem it is.

The problem is further exacerbated by the tendency of these capital market-driven realignments in exchange rates to mask and distort underlying comparative advantage for significant periods of time. It is not clear just what policies should be to deal with this problem, other than to note that more generalized floating would probably reduce the size of the realignments, thus reducing the need for adjustment, and that the policies referred to above to facilitate intersectoral mobility would help a great deal.

The Predatory Trade Policies of the European Community, the United States, and Japan Create Serious Adjustment Problems for the International Community

These developed countries are taking virtually no longer-term adjustments in their agricultural sectors in response to changing conditions in international markets, although U.S. agriculture has experienced a collapse in asset values and some restructuring. Instead, the European Community and the United States are engaged in a noisy and expensive export subsidy war, using the power of their national treasuries to dump their adjustment problems on other developed-country exporters and on the developing countries as a whole. Exporting developing countries, such as Thailand and Argentina, clearly lose from these policies, as do producers and landless workers in importing countries.

Professor Johnson finesses this problem somewhat in his paper, although he agrees to the second-best policy of establishing the ratio of domestic farm prices to domestic nonfarm prices at the same ratio as exists in international markets. The classic prescription, of course, is that a country should accept the subsidies of other countries only if they are expected to continue in the future.

This is one adjustment I don’t believe developing countries in particular should take, and for two reasons. First, I believe there is ample evidence that the United States will change its policies in the near future, and its policies have been largely responsible for the large decline in commodity prices in 1986 and 1987. Because of the burgeoning budget costs of the deficiency payment scheme, the United States is very likely to shift increasingly to expanded production controls and set asides, and to reduce the expenditures on deficiency payments. In the case of the European Community, there is also growing evidence that the budget costs of its policies are recognized as excessive.

The second reason I believe the developing countries should not accept these subsidies and bear the adjustment costs is that by taking counteractive measures they will make dumping more expensive and thus hasten the day the United States and the European Community will change their policies. The GATT provides for the use of countervailing duties and dumping penalties in such circumstances. I believe the developing countries should take advantage of these provisions and not impose premature and costly adjustments on their own agricultural sectors because of developed-country policies.

Let me conclude by once again complimenting Professor Johnson on his perceptive and well-done paper. If we could only induce policymakers to follow the guidelines he lays out in the last part of his paper, we would rapidly move to a more rational use of the world’s agricultural resources, to the benefit of developed and developing countries alike.

Chu S. P. Okongwu

Federal Minister of Finance


Mr. Chelliah’s paper has achieved much in clarifying issues and illuminating the surrounding darkness in some of the uncertain areas of the role of fiscal policy in growth-oriented adjustment efforts. The distinction between the short-run and the medium- to long-run impact of fiscal measures sheds much light on the limitations of fiscal policy, depending upon the time frame and considering the relative stages of economic development. It is also useful to note the issue raised in the paper regarding the concept of budget deficit as defined by both the Fund and the World Bank, which the paper considers unsatisfactory as an indicator of the expansionary impact of the budget. In its main thrust, an important role is clearly assigned to fiscal policy in the effort to effect structural adjustment through growth-oriented programs. However, some trade-offs are required in the choice and implementation of various fiscal measures.

From the standpoint of developing economies, the basic assumptions of Mr. Chelliah need be stressed, namely, a mixed economy framework with a dominant public sector with some services provided free of charge or subsidized. These characteristic features, particularly the issue of subsidies and the dominance of government, have been seriously frowned at and indeed considered objectionable by both the Fund and the World Bank programs, as they are largely held responsible for budget deficit and inefficient allocation of resources. Notwithstanding the realities of some negative impact which the dominance of government can foster, the fact is that given the weak private sector in many developing countries, especially in Africa, as Mr. O. Aboyade puts it, “the only feasible institution left for articulating, inspiring, guiding, and managing the development process in socially desirable directions is the machinery of state power.” Because private initiative is not always forthcoming in vital areas of long-run economic development owing to inherent difference between the way potential investors read the cost-benefit signals of the future and the way in which public authorities may read the same signals, the public sector may maintain its dominance over time. Many governments from developing as well as industrial countries perceive some industries and other economic activities to be of strategic importance for both economic and non-economic reasons, and, therefore, fiscal policy design and analysis must take account of these realities. This, of course, is not to detract from the fundamental role of the government to direct resources to the productive sectors of the economy and encourage their efficient utilization. Nor should the pursuit of social justice and equity be unduly sacrificed in the operation of fiscal policy for purposes of structural adjustment with growth. This means that fiscal policy must constantly seek to synchronize and optimize sometimes an apparently conflicting set of needs and objectives of efficient resource use, growth, and social justice.

Issues that must be carefully noted in the treatment of fiscal deficit relate to definition and the relevance of assumptions. Mr. Chelliah has seriously called to question both the Fund and World Bank concept of fiscal deficit defined as “the difference between government’s total expenditures and current revenues; thus it becomes equal to total net borrowing by the government which finances the deficit.” The basic problems are the apparent limitations imposed by the use of budget deficit so broadly defined as “an indicator of stimulus to aggregate demand.” Because of the central role of budget deficit in Fund/Bank programs, the need to re-examine its definition and composition cannot be overemphasized. Since the source of financing influences the impact of the budget on aggregate demand, any figure that represents budget deficit should have taken fully into account only the net effect of that source of finance. For the various reasons and illustrations given by Mr. Chelliah, there appears to be strong evidence in support of his views.

The Fund’s model program assumes excessive growth of demand as the basic cause of balance of payments disequilibrium and the reduction of that demand as the basic cure. Evidence abounds to prove that that is not always the case. Mr. R. H. Green notes, “In cases of economies in long-term structural crises (e.g., Ghana and, for different reasons, Uganda) suffering from sustained export purchasing power weakness (e.g., Zambia) or ravaged by international economic depression, the causal factor behind imbalances is clearly not excessive expansion of demand. Rather, it is contraction of the capacity to import to maintain capital stock and sustain agricultural production growth equal to that of population.” In circumstances such as these, where supply-side measures are warranted, fiscal measures should be careful not to make aggregate demand the whipping dog. The point has been made that in financing budget deficits, circumstances differ from country to country and therefore the same measures cannot be applied across the board. This should be a universally accepted position. It is consistent with the Fund’s principle of a case-by-case approach in dealing with members. Specifically, although the macroeconomic approach to stabilization assumes that the fiscal deficit could be reduced by raising taxes or cutting spending, the question regarding which tax rates should be changed, which new revenues should be adopted, and which expenditures should be reduced or expanded depends on individual countries’ relevant economic and socio-political circumstances. The characteristics of an economy affect the tax system through their influence on the demand for goods and government services in general and through their effect on tax bases. A largely agricultural economy has less demand for public services and provides limited tax bases compared with an urban economy that relies substantially on imports and has a large manufacturing sector. All these, including the political and cultural factors, must be taken into account in working out a tax system and structure for growth purposes. Nothing could be so politically frustrating and economically destabilizing as the imposition of imported and irrelevant tax systems and structures.

Taxation for revenue purposes has been broadly effective in developing countries, although it must be stressed that the level of effectiveness varies from country to country and on average is very much below that for developed countries. For most of Africa, according to Mr. Tanzi, the ratio of tax revenue to gross domestic product (GDP) ranges from about 10 to 25 percent. For the underdeveloped countries as a whole, the proportion ranges between 8 to 15 percent, and the bulk of it is accounted for by import and export duties while income taxes remain relatively unimportant. Because of the dominant role of taxes in current revenue, Mr. Chelliah is right in stressing that tax revenue must rise significantly if deficits are to be brought under control. But since substantial increase in tax revenue cannot be achieved without faster economic growth, the fiscal policymaker is locked up in a vicious circle whose exit is to be found only in the medium to long term. This underscores the difficulty of substantially reducing fiscal deficit in the short run. A resort to growth-retarding taxes for purely short-run solution to the problem of the fiscal deficit might make no economic sense in the long run. In certain circumstances, it might even be necessary as part of tax reforms, to encourage changes that could produce less impact on the fiscal deficit in the short run but would have desirable supply-side effects on the economy over the medium term. Essentially, the implication suggests the need for some limited compromise on reduction of fiscal deficit in the short run if the program is to lead to structural changes and growth in the longer run.

The discussion of the relevance or otherwise of various fiscal instruments, particularly with regard to developing countries, is comprehensive and offers useful elements that should be taken into consideration in effecting tax changes for revenue and growth purposes. Mr. Chelliah would advocate taxes on selective consumption, value-added tax, retail sales tax in small countries, and tariffs on imports as well as direct taxes on corporations. Considering the relevant caveats to some of the tax prescriptions, there would easily be a general consensus on the position taken by Mr. Chelliah. The choice of specific fiscal instruments, however, affect work effort, exports, productive investment, savings, capital flight, foreign investment, and so on. In this connection, and in order to realize the potential taxable capacity of its economy, the government of any developing country would need to thoroughly examine the various forms of taxation open to it, subject each kind of tax to its probable effects on the propensity to save, the administrative costs of collecting it, the incentive to work or continue to perform the same service, the foreign exchange implications, the impact on the stability of prices, and the extent to which it facilitates distributive equity.

For growth purposes, shifting resources from consumption to capital formation could be effected through customs duties, which play a strategic role in reducing luxury consumption of imported goods. This, coupled with a selective system of manufacturers’ excises, could stimulate domestic output. In the agricultural sector, careful attention must be given to the tax instruments used since this sector constitutes a large share of GDP in many developing countries, especially in Africa. Because of the many inherent constraints—administrative, land tenure systems—it may be unrealistic to expect much in terms of directly enhancing agricultural productivity through taxation. Implicit taxation through the pricing policy of the marketing boards has been found to be unworkable and indeed in some cases counterproductive. Nigeria has since scrapped this system, having learnt from experience, although we still have to put in place an implement or of sensible guaranteed minimum prices.

With regard to Mr. Chelliah’s position that direct tax reform should be given a high priority role in Fund-supported programs, on balance there is skepticism about the beneficial impact of such an exercise. There is a consensus on the fact that direct income taxes are generally relatively high in developing countries, even though the proportion of population that pays income taxes in Africa, for instance, is about only 2 percent compared with some 35 to 40 percent in Western Europe. There are the overwhelming problems of defining income, the difficulties of assessing any one individual income, even after overcoming the definitional problem and the obstacles in fixing a rational system of rates and the operational problems of collections and effective compliance. In the case of individual incomes, tax problems also arise with respect to selecting the appropriate adjustment for the family unit, the appropriate level of initial exemption, and deciding whether foreign-source income should be taxed. In view of these problems, and considering the fact that greater possibility exists for achieving growth and balance of payments objectives through indirect taxes, there may be justification for the Fund’s action in giving less emphasis to revisions of direct taxation in Fund-supported programs.

Obviously, under direct taxation, important attractive sources of revenue in many developing countries are taxes on business and corporate income. In this case, there is relative ease of collection, and it appears administratively and politically painless, although the sophistication of the large multinational corporations are often reflected in their devices to avoid or evade taxes. However, as Mr. Chelliah has noted, it is necessary to encourage savings and investment and thus promote growth by providing for a low rate of tax on corporate profits and accelerated depreciation. In sum, it is relevant to remind ourselves of Herberger’s commandments on tax policy in developing countries:

  • If tariffs are used, keep effective rates reasonably uniform.

  • If tariffs become excessive, use export incentives.

  • Make tax systems as simple and neutral as possible.

  • Avoid excessive income tax rates.

  • Avoid excessive tax incentives.

Because of the theoretical underpinnings of Fund-supported programs, largely rooted in the Keynesian aggregate demand hypothesis, reduction in current expenditure is considered the cure for balance of payments disequilibrium. Of course, from cases cited earlier, it would appear that that was not a settled issue. Nevertheless, fiscal policy measures taken to influence the aggregate level or rate of growth of domestic demand and absorption would, as in the case of revenue measures, have to be based on country-specific factors. Differences regarding individual countries’ expenditure decisions must take into account changes in demographic factors, sociological concerns, sectoral structure of the economy, technological and environmental factors. And this probably explains “the tendency for Latin Americans, Asians and industrial countries to spend less than would be expected on general public services and for African countries to spend more than would be expected.”

However, the desirable goal which is to match current expenditure with current revenues necessarily demands expenditure restraints which involve, inter alia, cessation of government activity in the loss-making non-core public enterprises and the removal of subsidies. The distinction drawn by Mr. Chelliah between core and non-core sectors is important because it would be extremely difficult for any program to justify total elimination of all subsidies or privatization of all public enterprises, given the hard fact that in many developing countries with a very weak private sector, government is the prime mover of the economy. This relatively dominant position of government in overall economic activity must, of course, be gradually made to diminish as the development process accelerates.

The lessons of experience with the design and implementation of Fund and World Bank programs in developing countries clearly reveal that socio-political sensitivities impose limitations on rapid reduction in fiscal deficits, particularly on the removal of subsidies. Mr. Chelliah’s cautious approach to the matter is relevant. Only on grounds of disincentives to producers and significant distortions in the allocation of resources would removal of subsidies be clearly justified. Appropriate levels of export subsidies, subsidies in favor of the poor, and subsidies on the use of particular inputs in furtherance of the public interest should be maintained.

It is, perhaps, not surprising that empirical investigation has so far failed to establish a clear-cut link between fiscal policy and savings, investment and growth rate. The well-known proposition of the standard Keynesian models that has largely influenced the design of Fund-supported stabilization and growth-oriented programs is that reduction in government expenditure or an increase in taxation would have a multiplier effect on the level of real income, at least in the short run. The difficulty of establishing clearly this relationship arises because of the existence of close linkage between fiscal policy and monetary policy, which is generally much tighter in developing countries than in industrial countries. This link between fiscal deficit and money supply changes imposes severe limitations on the use of monetary and fiscal policies as independent policy instruments in developing countries. This probably explains the inclusion in Fund-supported programs of ceilings on credit to government or public sector for the purpose of controlling public sector deficit and the growth of total domestic credit.

Thus, although in theory the growth role of fiscal policy is explicitly articulated, in practice, especially in developing countries, its independent impact is not impressive. For instance, in her study that focused on the specific issue of fiscal adjustment in Fund programs comparing the three-year average of the rates of growth beginning with the program year with the three-year average prior to that year, Margaret Kelly of the Fund found that for the 48 upper credit tranche stand-by arrangements implemented over 1971-79, 25 cases showed a decline in the average growth rate while the other 23 showed an increase. As has been noted, the relative unimpressive impact of fiscal policy on growth could, in addition to reasons given earlier, be traceable to the lack of mobilization of the society. Experience and the development process underscore the need for mobilization of the society and its entire resources to the task of economic transformation as the basis for effectiveness of growth-oriented economic policies.

Given available evidence, fiscal policy has an important role to play in the process of economic growth. Therefore, growth-oriented programs must continue to accord it priority. Although empirical investigation has so far revealed the limitations of fiscal policy which makes it difficult to establish a clear-cut linkage between it and growth, the quality and efficiency of fiscal instruments remain important for growth. Largely because of the problem of structural adjustment and the rigidities that prevent the play of market-induced adjustments in many developing countries, the short-run impact of fiscal policy on growth is uncertain, if not negative in some cases. But in the long run, with the removal of serious structural constraints, fiscal policy comes into its own.

In order to enhance the growth-promoting role of fiscal policy, the design of adjustment programs should adequately address the appropriate determination of fiscal deficit, the proper choice of fiscal instruments that takes account of socio-political sensitivities, and the factor of social mobilization, as well as flexibility in the fiscal ceilings.

Vito Tanzi

Director, Fiscal Affairs Department

International Monetary Fund

There are two realities with which the majority of developing countries must deal today. The first is the debt crisis, which has sharply reduced these countries’ access to external resources and which, because of the large foreign debts, has made it highly desirable for them to grow at a sustained pace so as to reduce over time the debt burden. The second reality, clearly recognized in Mr. Chelliah’s contribution, is that excess demand originating from the public sector has been, at least in part, responsible for the balance of payment difficulties that many of these countries have encountered. These two realities require that the public sector’s claims on the economy be reduced while at the same time the productive capacity of the economy is stimulated.

Mr. Chelliah’s paper deals with the fiscal policy that would be desirable in an economy that includes some planning to meet basic needs and where, by necessity, there is a wide scope for public enterprises and that wishes to achieve stability with growth and social justice. Mr. Chelliah addresses two fundamental questions: how does one measure this excess demand originating from the public sector? And, assuming that that excess demand can be measured in a meaningful way, how should it be eliminated to achieve stability with growth and social justice?

The Measurement of the Fiscal Deficit

As to the question of measuring the excess demand, Mr. Chelliah discusses some limitations of the common or conventional measure of the fiscal deficit that, he says, the Fund uses. He calls this measure the overall deficit defined as the difference between total government expenditure and government’s current revenue. He mentions three limitations of this measure: (a) the differential impact on demand associated with different tax and expenditure categories; (b) the endogeneity of tax revenue; and (c) the impact of different sources of deficit financing.

The first of these limitations has a long history. In fact, Haavelmo’s balanced budget theorem which recognized a different demand impact of a dollar change in taxes and in real government expenditure is an early version of it. Bator’s later argument that transfer payments and real expenditures of the government have dollar per dollar different demand impacts is another. In the 1960s this argument was very popular. It perhaps received the most explicit expression in a book written by Bent Hansen dealing with fiscal policy in seven OECD countries. The problem is that while one should recognize that different taxes may have different demand effects and that different types of expenditures are also likely to have different demand effects, it is difficult to agree on specific and objective weights to be assigned to these differences. It is perhaps because of this reason that the early enthusiasm in this approach quickly vanished and today hardly any attention is paid to these differences, except, perhaps, in traditional and large econometric models of the economy. Another reason is that by putting the emphasis on demand effects this approach reflects an essentially Keynesian view of the role of fiscal policy.

The second limitation mentioned by Mr. Chelliah (the endogeneity of tax revenues) has also a long history; it goes back at least to work done in the 1950s by Cary Brown and others. The question here is the following: should one take as the index of the needed fiscal adjustment of the country the deficit that the country actually has in a given period; or should one adjust that deficit for the effect of the business cycle on revenue and expenditure? Obviously, as economic activity declines in a recession, tax revenues are likely to be lower than in a full-employment situation, ceteris paribus. Some expenditures, unemployment compensation for example, are also sensitive to the cycle.

This point raised by Mr. Chelliah is certainly potentially important. Behind it there is the assumption that, since a recession increases the size of the unused capacity in the economy, a larger public sector demand can be accommodated or may even be desirable to achieve full employment. It is a point that has been at the center of an ongoing debate for guiding fiscal policy in industrial countries. The full-employment budget surplus, a concept introduced in the 1962 Economic Report of the President of the United States and one that played a large role in determining economic policy in the Kennedy and Johnson era, was an expression of this aspect. The problem is that in today’s world the concept of a full capacity level of output has lost much of its precise meaning for a variety of reasons but mainly because of the greater openness of many economies. Certainly, this concept is suspect for developing countries where capacity utilization and full employment are ambiguous concepts. In these economies and, perhaps, also in many industrial countries, the major constraint on output is not the labor supply or even the productive capacity of the capital stock, but foreign currency availability. A government that attempted to push aggregate demand because of unutilized domestic resources would soon run into a foreign exchange constraint. Thus, again, although Mr. Chelliah’s point is an important one, its relevance for developing countries is likely to be limited.

Mr. Chelliah is certainly right in arguing that different sources of financing have different demand effects. Clearly, central bank financing, commercial bank financing, bond financing, foreign financing, domestic suppliers’ financing, and so on, will affect aggregate demand differently. This is an aspect that has not received the attention that it deserves. Most observers have not recognized the variety of ways in which the fiscal deficit can be financed in developing countries. I have some difficulty, however, in accepting Mr. Chelliah’s conclusion that one should focus only on bank-financed deficit. There are certainly lots of other reasons to focus on different measures. Most important among these is to prevent public debt, both domestic and foreign, from growing at too fast a pace. Another is the need to limit the crowding out of the private sector.

Mr. Chelliah also argues that the borrowing by the government on behalf of the public enterprises should be excluded from the deficit. The reason that he gives is that “. . . that part of the credit is strictly not for government purposes.” This is certainly an interesting argument which merits serious consideration. One could argue that if those public enterprises had been private, and if they had done the same amount of borrowing in the capital market, the fiscal deficit would have been lower while the total demand for loanable funds would be the same. This is an argument that has attracted a lot of attention in Italy where the image of the “government as a banker” that just intermediates between the financial market and the public enterprises has been discussed. Several Italian authors have argued, just as Mr. Chelliah does, that this particular part of the deficit should be excluded.

The problem with the above argument is that it implicitly assumes that the public enterprises would do exactly the same amount of borrowing and presumably would produce the same output at similar costs, if they were private enterprises. It also assumes that they would borrow, at presumably identical conditions, regardless of the losses that they might be making. This is unlikely to be so. Many of these enterprises survive because the government is there to provide funds, and one can add that what they produce and the way they produce it is certainly influenced by their “publicness.” A study by the Fiscal Affairs Department has shown that these enterprises have contributed significantly to total fiscal deficits and to credit expansion. If the government were not there, many of those enterprises would disappear, or at least they would borrow much less since they would have to pay considerably higher interest rates on loans that they obtained from the capital market. Thus, although Mr. Chelliah’s argument has some validity for those public enterprises which are run on efficiency criteria and which may be as efficient as the private enterprises, it certainly has its limitation when it is generalized to all enterprises. In fact, Mr. Chelliah himself, later in the paper, calls for the elimination of loss-making public enterprises.

Mr. Chelliah attaches particular importance to what he calls the current account fiscal deficit. This is the difference between government revenue and “current” government expenditure. It is argued that this difference measures the government contribution to the total saving of the economy and, thus, to growth. On the surface this deficit concept appears very attractive and has thus many supporters. After all governments are supposed to mobilize resources and to contribute to growth and many assume that the government’s contribution to growth is measured predominantly through its effect on total investment. This assumption is, of course, a direct outcome of the Harrod-Domar type of literature that was so popular in the 1950s and the 1960s. On closer scrutiny, however, this concept quickly loses much of its magic at least in practice if not in theory. There are several reasons for this.

First, whether the government spends on current expenditure or on what is conventionally classified as investment, the short-run impact of that expenditure on the balance of payment disequilibrium will be the same. In fact, one could go further than that and argue that, at least in the short run, investment spending by the government may have a larger negative impact on the balance of payment than other kinds of spending. The main reason for this is that the import content of investment spending is likely to be higher on the average than the import content of current spending.

Second, investment may be as wasteful as current spending. One could even argue that an unproductive investment which relies much on imported capital equipment is likely to contribute far less to both the welfare of the citizen and the growth of the economy than much current spending. The economic history of many countries is full of horror stories of highly wasteful public investment projects which after getting a country into foreign debt became useless white elephants.

As economic development economists have often argued, some current spending on health, education, administration, and so on, can have important effects on growth at least over the longer run. More recently a lot of emphasis had been placed on the need to spend on recurrent costs so that the existing infrastructure of developing countries can provide or continue to provide badly needed services. If a country favors investment over these highly desirable recurrent expenditures, it may badly misallocate available resources and reduce the rate of growth. There are too many examples of new roads being built at very high cost while the existing roads are allowed to deteriorate to such an extent that they become impassable, and of hospitals that cannot provide the services for which they were built because of lack of nurses or equipment. And there are examples of vehicles being unutilized because of lack of spare parts or gasoline. Some of these problems are recognized by Mr. Chelliah. Finally, the dividing line between what is classified as current and what is classified as capital is, in the real world, an arbitrary one that can be moved up and down depending on the picture that policymakers may wish to present to the world. (The rules that determine which expenditures should be classified as capital expenditure vary from country to country and, apparently, even in the same country over time. Even the comparison of capital expenditure by, say, the governments of Germany and the United States is difficult to make because of these reasons.)

Thus, in conclusion, I am skeptical that current account deficits may tell us as much as Mr. Chelliah argues they do although I would certainly be as concerned as he is about a country that is running a fiscal deficit even when investment expenditure, however defined, is netted out. For sure the current account deficit will tell us nothing about the impact of fiscal policy on the balance of payment and perhaps not much on the impact of fiscal policy on growth.

There are many other issues that arise with the conventional measures of fiscal deficit. Some of them are of particular relevance within the context of an adjustment program. While I cannot fully discuss them here, I would like to at least mention a few. Should one adjust the conventional measure for the impact of inflation? Several participants at this conference argued that one should. However, when the rate of inflation is high, there are considerable problems with both deficit measures that include a correction for inflation and those that exclude that correction.

Another big problem encountered in the use of fiscal deficit measures is in the treatment of arrears. Normal cash measures do not show these arrears; therefore, a country could increase its public expenditure but delay payments thus showing no change in the “overall deficit” while it would in fact be increasing aggregate demand. Arrears have become particularly relevant in connection with foreign debt. One should always specify in a measure of the deficit whether unpaid interest payments on foreign debt are being registered as deficit or not. For example, what happens to a deficit measure when interest on foreign debt is rescheduled?

Other problems arise from the fact that very often one measures the fiscal deficit only for the central government. However, other parts of the public sector may show large fiscal deficit. One such part that has attracted considerable recent attention, but still very little analysis, is the fiscal deficit of central banks. In some Latin American countries, central banks have become important fiscal agents. Through their operations governments promote domestic spending without having the budget reflect this contribution to aggregate demand. The fiscal deficit may appear also in public enterprises, in local governments, in social security institutions, or in stabilization funds or marketing boards. If these various components of the public sector were not interconnected, as is, for example, the case in the United States, where the Federal government, the Federal Reserve, and the local governments are essentially independent and where public enterprises are virtually nonexistent, one could perhaps still emphasize the deficit of the central government and attribute to it a central role. The trouble is that when these various components are interconnected, as they are often in many developing countries, one may find that when the deficit is squeezed out of the central government it may reappear in the central bank or in the public enterprises or even possibly in the local governments or in some other public institutions. In these circumstances an adjustment program that focuses on the deficit of the central government may not bring about the necessary adjustment if the reduction in the central government deficit is fully or partly compensated by an increase in the deficit in other parts of the government.

One final problem worth mentioning is the following. Fiscal deficits may be reduced through once-and-for-all changes. For example, a country may sell public assets; or it may introduce once-and-for-all measures such as tax amnesties; or public sector wages may be squeezed well below their long-term political and economic equilibrium; or temporary taxes are levied. These various measures achieve the objective of reducing the size of the deficit in the short run but they do little or nothing toward a permanent improvement of the fiscal situation. For this reason, in some cases, it would be desirable to present a measure of the fiscal deficit that would remove the impact of these short-term measures. This adjustment would give an underlying or core deficit which would better reflect the fiscal situation of the country over the longer run. Such a correction would be desirable although in many cases it might be difficult to do in practice.

A deficit may be like an elephant: one always recognizes it when he sees it even though it may be difficult to measure or describe it in a way that is satisfactory to everybody and for every purpose. Recently, I started writing a paper on fiscal deficit concepts. So far I have already identified about 15 different measures, each of which could be justified for some use and the list is still growing. The conclusion of this is that it is difficult to measure precisely the impact of fiscal policy on aggregate demand, inflation, and other macroeconomic variables. The use of just one number to assess that impact should be de-emphasized and a much closer scrutiny of the fiscal situation should be made. It is for this reason that much more attention needs to be paid to the structural aspects of fiscal policy. I was very pleased to listen to various speakers, such as Michael Bruno, Jeffrey Sachs, Jacob Frenkel, as well as Raja Chelliah, argue that the structural aspect of fiscal policy may be as important as the short-run demand management effect.

This takes me to the second question raised by Mr. Chelliah-—how to eliminate excess demand originating in the public sector while still pursuing growth and social justice.

How to Reduce Fiscal Imbalances

About half of Mr. Chelliah’s paper deals with ways in which fiscal imbalances can be reduced. He assumes that in the short run fiscal policy can only influence demand while in the medium run it can also be oriented toward increasing efficiency. Although this is the prevalent view, I have always had some problems with this distinction. This distinction between the short run and the medium run should not be carried too far for several reasons.

First, it is difficult to tell where the short run should end and the medium run should begin; economic policy often becomes just a series of short-run programs whereby the preoccupation with the next few months distracts policymakers from basic adjustment. Second, many fiscal measures have long-run implications especially because of their impact on expectation. Here again it is perhaps useful to point out that the Keynesian treatment of expectations continues to prevail in this area. The effect of a tax increase is assumed to be a reduction in demand in the immediate period; in other words, consumption depends mainly on current income. The tax increase is supposed to have no implications for the future. Short-run measures may increase the difficulties of achieving adjustment over the medium run, however, especially in the absence of liquidity constraints and, of course, they may not have the expected effect on current consumption. Third, some tax changes may have short-run supply-side effects on the economy. For example, the introduction of an export tax is likely to reduce exports and the foreign exchange available to the country.

Much of Mr. Chelliah’s paper, however, deals with ways to bring down the deficit over the medium run. I am in broad agreement with a good deal of what he says although I have some difficulty with some aspects of it.

Mr. Chelliah deals separately with the revenue side and the expenditure side of public sector finances. He argues that in a country with a large fiscal deficit the level of taxation must rise substantially over the medium run while the tax structure must exert a favorable influence on the economy. He recognizes that in the majority of developing countries the tax structure leaves much to be desired and he favors indirect taxes over direct taxes but warns that indirect taxes should not distort the relative prices of the factors of production and should not lead to cascading. He suggests that a general sales tax, especially a value-added tax, would be a desirable feature for these countries but he makes what to me is a strange recommendation: that smaller countries should introduce a retail sales tax. In our work, in the Fiscal Affairs Department of the Fund, we have found that it is very unlikely that a developing country, be it large or small, can administer a retail sales tax in a satisfactory manner.

Another suggestion with which I have some difficulty is the idea that these countries should introduce an inheritance tax, if it is not already being levied. Again, our experience indicates that these taxes never play much of a role in these countries and, if they did, they would have effects, such as to stimulate consumption and to induce capital flight, which would be most unwelcome for developing countries. Mr. Chelliah favors an income tax with a single rate on the assumption that a single rate would be easier to administer than highly progressive income taxes. While I agree that a single rate would be easier to administer, I find the level of that rate that he suggests—30 percent—to be very high. In general, developing countries should aim at broadening the base of the income tax in order to be able to raise revenue while applying relatively low rates.

One aspect of his paper that I find puzzling is the total absence of reference to foreign trade taxes. These taxes are not even mentioned when in fact they account for about a third of all revenue of the developing countries and they probably are more guilty of distortions than any other group of taxes. If countries are truly concerned about growth, it is the foreign trade taxes that they must first reform. In many cases the export taxes must be reformed out of existence.

Mr. Chelliah recognizes that when the level of taxation is high, one must inevitably look at the expenditure side to reduce the fiscal imbalance. The higher the level of taxation, however, the more important it is that its structure have desirable features. Thus, fiscal adjustment must always include an improvement in the structure of taxation if the economy is to perform efficiently and if the rate of growth is to be kept at a high level.

Mr. Chelliah suggests that fiscal adjustment over the medium run, on the expenditure side, must involve: (1) a freeze on employment and wages in the public sector; (2) a reduction of subsidies; (3) introduction of zero-base budgeting to analyze the various items of the budget; and (4) some pruning of inefficient capital expenditure. I do not have difficulty with the last three of these suggestions, but I would worry about public sector wage freezes since these are often reversed in the future so that they may bring about a short-run fiscal adjustment that is not sustainable. When these freezes are not reversed, they lead to inefficiency and corruption in the public sectors.

Mr. Chelliah focuses much of his attention on current expenditure, in line with his belief that the current account deficit is the one to worry about. But, again, some of his discussion indicates that he may not be as convinced on that point as he seemed to be in the earlier part of the paper. For example, (a) he accepts the need to prune some capital expenditure; he recognizes that (b) some current expenditure leads to higher return on capital expenditure; (c) some loss-making enterprises should be closed down; and (d) transport allowances, supplies and materials, spare parts, use of telephone, and electricity may have been cut excessively in some countries; in other words, he recognizes the need for some increase in current expenditure.

Mr. Chelliah criticizes the Fund for having tried to reduce subsidies in some countries and states that one gets the impression that the Fund is always against subsidies. He argues that subsidies may be efficiently provided and may help the poor and he mentions an Indian example to justify his belief. In contrast to his example, however, one could use many other examples from other countries to show that subsidies have not only increased the fiscal deficit but have also, in many cases, led to serious misallocation of resources without helping the really poor. In any case, I feel that he overstates his case by saying that the Fund is always against subsidies. The Fund has definitely been against inefficient subsidies and it has taken a position against subsidies when this seemed to be the most efficient way of reducing an unsustainable fiscal deficit. It has remained neutral in other cases.

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