Resilience and Growth in the Small States of the Pacific
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Chapter 10. Strengthening Fiscal Frameworks and Improving the Spending Mix in Small States

Author(s):
Hoe Khor, Roger Kronenberg, and Patrizia Tumbarello
Published Date:
August 2016
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Author(s)
Ezequiel Cabezon, Patrizia Tumbarello and Yiqun Wu 

The unique characteristics of small developing states make fiscal management more challenging than elsewhere.1 Most important, the indivisibility of the provision of public goods and public sectors, which are the main employers, introduces rigidities into budgets, tilting the composition of spending toward recurrent outlays. With limited fiscal resources, high recurrent spending can crowd out capital spending, leading to underinvestment in infrastructure and other growth-enhancing areas. At the same time, small states generally face greater revenue volatility than other country groups (IMF 2013; and see Chapter 2 in this volume) owing to their exposure to exogenous shocks and narrow production bases. This is particularly true for fragile states and commodity exporters. Small states often lack the capacity to weather revenue volatility for two reasons: they cannot finance temporary fiscal shocks because domestic banking systems are shallow, and they have limited access to international capital markets (Holden and Howell 2009).

Despite the lumpiness (relative to small GDPs) of capital projects, fiscal frameworks are not typically designed with a multiyear perspective, which would allow smoothing of expenditures over the business cycle. Although foreign assistance has provided some countercyclical support during downturns to aid-dependent small states, the volatility of revenue has generally resulted in volatile spending patterns and procyclical fiscal policy. Reflecting the recurrent spending rigidities, budget pressures typically, and primarily, affect capital spending. This means that already-strained capital budgets face further cuts in the event of external shocks, which further undermines longer-term growth prospects.

Assessing the fiscal stance of small states is complicated. Because of revenue volatility, especially in Pacific island countries, headline fiscal balances do not always accurately reflect underlying fiscal positions. However, data deficiencies, capacity constraints, and structural changes in the economy make it difficult to estimate meaningful cyclically adjusted or structural balances based on output gaps (IMF 2014a). Additional challenges include the existence of extrabudgetary funds not integrated into budget presentations, and the difficulty of measuring capital spending when projects are implemented outside the central government or controlled by planning ministries using different charts of accounts than those used by finance ministries.

Strengthening fiscal frameworks by isolating the budget from revenue volatility and shielding public spending (especially capital) could help increase small states’ resilience to shocks and boost potential growth. This means using fiscal anchors to smooth the volatility of revenue and capital expenditure over the business cycle and creating policy space for spending on infrastructure, health, and education. It also means focusing fiscal policy more on the medium term, as it should not be formulated on a year-by-year basis only. In addition, public financial management (PFM) reforms to improve the quality of public spending is key to supporting growth.

However, policies need to be tailored to the special challenges of small states (Box 10.1). The design of fiscal anchors should be country specific and kept simple. Medium-term fiscal estimates should focus only on main aggregates to facilitate the adoption of a multiyear budget framework. Using such a framework could, from a political point of view, also help contain spending pressure by better sequencing the implementation of capital projects. Such spending pressure is particularly acute in small states given their development needs.

Box 10.1From Best Practice to Best Fit: Lessons from Small States

Small states face extra challenges relative to comparators in strengthening fiscal frameworks and achieving the right mix of public spending, due to political economy considerations, capacity constraints, vulnerability to shocks, and data issues. However, many of these states have achieved progress in handling the challenges described in this chapter. Some examples are reported in the following.

  • Mauritius: The new Public Financial Management (PFM) Act, which has yet to be adopted, looks to alleviate some of the budget execution difficulties, which led to the creation of special funds. The new government said it intends to eliminate the special funds and fully incorporate the related operations in the budget. Regarding the fiscal rule, authorities have adopted a liberal approach on its application, whereby (in principle legally binding) the debt target could be pushed out if it becomes difficult to achieve.

  • Jamaica: Its rule-based fiscal framework has the following two distinct but complementary components:

    • Macro-fiscal or quantitative—The overall fiscal balance path is calibrated over a trailing three-year window to achieve a debt ceiling of 60 percent of GDP at the end of March 2026. The path is based on projections of, for example, real GDP growth, inflation, and the interest rate. This component kicks in only after the IMF Extended Fund Facility Arrangement, but the fiscal targets under the program aim to achieve the same policy goal and can be seen as a de facto fiscal rule. An exceptionally large adverse shock could require a temporary deviation from the debt reduction path, and for this purpose an escape clause was built into the fiscal rule. The clause is limited to natural disasters, severe economic contraction, banking or financial crises, and a state of emergency; it may only be activated if the estimated fiscal impact of such shocks exceeds 1½ percent of GDP.

    • Institutional—This component has four elements: (1) strengthened budgetary procedures (and in 2015 the budget will be presented to Parliament before the start of the fiscal year for the first time in many years); (2) exclusion criteria—the fiscal rule covers the public sector at large, except for the Bank of Jamaica and public entities deemed commercial; (3) bolstering capacity at the Office of the Auditor General, with the auditor general responsible for monitoring compliance with the fiscal rule (as such, the office must be appropriately staffed to fulfill its expanded mandate); and (4) sanctions for infringing the fiscal rule, with the authorities initiating dialogue with the IMF’s Legal Department on the design of an enforcement mechanism.

  • Seychelles: The country is the top performer in Africa on health, nutrition, and population outcomes. Its health indicators compare favorably with some Organisation for Economic Co-operation and Development countries, reflecting long-standing government commitment to providing universal free basic health care and access to education. Health spending accounts for only about 3½ percent of GDP.

  • The Solomon Islands: The new Public Financial Management Act passed in December 2013 and the accompanying public financial management road map (2014–17) provide a coherent platform to anchor fiscal reforms; in particular by improving the quality of spending and enhancing budget planning.

  • Swaziland: During the country’s 2014 Article IV consultation, authorities agreed with anchoring the fiscal policy with a medium-term international reserve target of 5–7 months of imports, while exploring the options of a fiscal rule or a stabilization fund to help address the high volatility of fiscal revenues.

  • Timor-Leste: The estimated sustainable income rule has worked well to minimize the effects of revenue volatility, and it has also allowed Timor-Leste’s Petroleum Fund to grow to the equivalent of three times GDP.

Improving the Mix of Public Spending

Current spending rigidity is a key issue in small states, which results from the large share of current spending in GDP in these countries relative to others (Figure 10.1). In providing public services, small states face higher government costs per capita than other country groups, because public goods are indivisible and broad public services must be provided despite small populations, which creates diseconomies of scale. Indeed, the relationship between the size of the country and current spending is U-shaped; that is, the smaller the country, the bigger is its current government spending (Figure 10.2). Distance from key markets also raises import transport costs. All of these effects are worsened in microstates, while extreme remoteness and population dispersion compound the challenges in Pacific island countries (Figure 10.3).

Figure 10.1Current Government Expenditure

(Percent of GDP)

Sources: IMF, World Economic Outlook database; and IMF staff estimates.

Figure 10.2Current Expenditure and Population, 2003–13

(Percent of GDP)

Source: IMF staff estimates.

Figure 10.3Small States: Current Government Expenditure and Geographic Dispersion

Source: IMF staff estimates.

Note: Includes Antigua and Barbuda, The Bahamas, Fiji, Kiribati, Marshall Islands, Micronesia, Palau, Samoa, the Solomon Islands, St. Kitts and Nevis, Tonga, Trinidad and Tobago, Tuvalu, and Vanuatu.

The spending mix in small states is tilted toward current spending, despite infrastructure bottlenecks, which could impede higher real GDP per capita growth (Figure 10.4). The resultant underinvestment impedes sustainable growth. Despite large development and infrastructure gaps over the last 10 years, capital spending in the small states accounted for less than 20 percent of government spending, well below the average of 32 percent in low-income countries. An exception is Cabo Verde, off Africa’s west coast, which embarked on a large investment program in the past decade at the cost of recurrent spending.

Figure 10.4Infrastructure Quality: Electricity Generation per Capita, 2010

(Percentile ranks)

Sources: World Bank, World Development Indicators; and IMF staff estimates.

The composition of public spending matters in determining the impact of fiscal policy on growth in small states (Figures 10.5 and 10.6). Econometric results suggest that the higher the share of public investment for a given amount of public spending, the higher the per capita growth (Annex Table 10.1.1). Moreover, the impact of capital spending on growth is stronger in small states than in other country groups. The effect is even stronger in Asia and Pacific small states, consistent with their large development needs, both in terms of capital and human infrastructure. The IMF staff econometric analysis also suggests that increasing the share of capital investment will boost per capita growth, but expanding the deficit and increasing public debt after a certain threshold does not support growth. The threshold derived within the model, after which debt harms growth, is 30 percent of GDP for the Asia and Pacific small states, well below the 50 percent threshold that applies to the full sample. This calls for building buffers (keeping debt at manageable levels and having low fiscal deficits) and tilting the composition of spending toward capital outlays.

Figure 10.5Relationship between Real GDP per Capita Growth, Composition of Spending, and Public Debt

(Percent)

Source: IMF staff estimates.

Note: Data are for 1990–2012. High (low) capital means the share of capital spending is above (below) the median. High (low) deficit means the fiscal deficit in percent of GDP is above (below) the median.

Figure 10.6Relationship between Real GDP per Capita Growth, Composition of Spending, and Public Deficit

(Percent)

Source: IMF staff estimates.

Note: Data are for 1990–2012. High (low) capital means the share of capital spending is above (below) the median. High (low) deficit means the fiscal deficit in percent of GDP is above (below) the median.

Indeed, the statistical analysis presented below supports the view that such buffers (that is, keeping deficits or debt low) are good for growth—and even more so when spending is tilted toward capital investment. Nonetheless, although higher capital spending is good for growth, it is less so when it expands deficits too much and raises debt unduly. This calls for preserving fiscal space for growth-enhancing investment, including infrastructure spending.

Additional IMF staff findings based on an event analysis (Figures 10.7 and 10.8) show that, in small states, an expansion in government spending led by capital spending results in higher real GDP per capita and lower public-debt-to-GDP ratios than expansions led by current spending. In small states, government spending expansions driven by capital lead to a minimum increment in public-debt-to-GDP ratios of about 2 percent, but this soars by about 10 percentage points of GDP in government spending expansions led by current spending. The impact on growth of government expansion led by capital is also much higher during and after the episode than the impact on growth led by increased current spending.2 One important caveat is that event analysis does not determine causality, because it does not control for the endogeneity of the variables and it should therefore not be interpreted as such. The endogeneity issues are solved within the econometric analysis presented in Annex Table 10.2.1 by using the generalized method of moments.3 These results are in line with the analysis of the IMF’s October 2014 World Economic Outlook, which found that public investment raises output in a wide range of countries. However, relative to the World Economic Outlook, this chapter finds that, for small states, the impact of public investment on real GDP growth is somewhat lower than for larger states. This could be due to lower fiscal multipliers in small, open economies whose capital inputs are mainly imported, as well as weaker PFM frameworks that could prevent efficient public investment.

Figure 10.7Small States: Real GDP per Capita during Episodes of Government Expenditure Expansion

(Year-over-year percent change)

Source: IMF staff estimates.

Note: Data are for 1990–2012. Includes only public expenditure episodes that resulted in higher fiscal deficits.

1 Three-year average after the episode.

Figure 10.8Small States: Public Debt during Episodes of Government Expenditure Expansion

(Percent of GDP)

Source: IMF staff estimates.

Note: Data are for 1990–2012. Includes only public expenditure episodes that resulted in higher fiscal deficits.

Public spending efficiency in small Pacific states is lower than in other small states (Figure 10.9). In the Pacific island countries, a large share of government spending (current and capital) is allocated to health and education, relative to other small states, which is consistent with their large development needs (Figure 10.10). However, the relatively poor outcomes on human development indicators, despite such spending, can be explained by the high cost of providing these services in small remote islands. By looking at the relationship between population dispersion and efficiency in public expenditure (proxied by the ratio between education and health outcomes and the share of health and education spending as a percent of GDP), we find a positive relationship between population density and efficiency indicators in public expenditure (Figure 10.9). High population dispersion is associated with less efficient education and health expenditure (that is, positive slopes) with a correlation of 0.3–0.4. While remoteness and dispersion matter, recent analysis (Haque, Knight, and Jayasuriya 2012) points to the need to improve the quality of public spending by accelerating PFM reforms.

Figure 10.9Measures of Efficiency of Public Spending and Population Dispersion, 1990–2012

(Percent of GDP)

Source: IMF staff estimates.

1 Density computed as inhabitants per square kilometer. The variable was rescaled by taking the log of the density multiplied by 1,000.

2 Efficiency measured as secondary school enrollment rate divided by public education expenditure-to-GDP ratio.

3 Efficiency measured as life expectancy divided by public health expenditure-to-GDP ratio.

Figure 10.10Health, Education Expenditure, and Selected Human Development Indicators

Sources: World Bank, World Development Indicators; and IMF staff estimates.

1 Excludes advanced economies.

Box 10.2Quantifying the Opportunity Cost of Building Fiscal Buffers in Pacific Island Countries

Policymakers in small developing states face a key fiscal policy choice: building fiscal buffers to enhance resilience to shocks—including natural disasters—or funding development spending. When a government expands fiscal space by accumulating public savings instead of financing spending for development needs, it forgoes the rate of return on the associated public investment. The opportunity cost of building fiscal buffers can be used to assess the optimal mix between building fiscal space and capital spending.

IMF staff estimated the social return on public investment assuming that it equals the marginal productivity of capital for a group of Pacific island countries. Following Caselli (2007), they calibrated a Cobb-Douglas production function for the group using data on output and investment from the Penn World Table and World Economic Outlook database for 197–2010.

The results suggest that several Pacific island countries enjoy a high rate of return on capital. And as such they would benefit from capital spending, which is consistent with these countries’ large infrastructure needs (proxied by the Human Development Index). The social return on capital in these countries is also in line with the return in low-income countries.

The IMF staff also estimated two measures of fiscal space: one based on the IMF/World Bank debt sustainability analysis (that is, a fiscal liquidity indicator is derived by measuring the average gap over the medium term between the debt-service-to-revenue ratio of public and publicly guaranteed debt and an indicative threshold after which the debt becomes unsustainable), and a second measure calculated as the difference between the actual debt relative to GDP and an estimated sustainable debt (as in Ostry and others 2010) implied by each country’s historical record of fiscal adjustment.

Figures 10.2.1 to 10.2.3 shed light on the room for fiscal maneuvering in Pacific island countries. A plot of the estimated cost of building buffers against the Human Development Index—a proxy for infrastructure needs—suggests that some countries stand to gain the most from increasing the share of their budget devoted to capital spending. When plotting the three different measures of fiscal space against the index, even though they are different, the measures provide a similar ordering of countries across methodologies in the size of the fiscal space or the opportunity costs of building buffers.

Figure 10.2.1Opportunity Cost of Building Fiscal Buffers and Human Development Index

Source: IMF staff estimates.

Figure 10.2.2Fiscal Space and Human Development Index

Source: IMF staff estimates.

1 Fiscal space measured by the gap in the IMF-World Bank Group’s debt sustainability analyses between the threshold of the public and publicly guaranteed external debt-service-to-revenue ratio and the forecasted baseline path of the same ratio.

Figure 10.2.3Fiscal Distress and Human Development Index

Source: IMF staff estimates.

Coping with Revenue Volatility

Revenue volatility in small states is larger than in developing non–small states, because the revenue base is narrow and subject to several exogenous shocks, and this is expected to continue due to the recent large drop in oil prices.

The sources of volatility vary across small states and depend on cyclical and noncyclical factors (Figure 10.11 and Annex Table 10.1.2). On average, revenue shows strong procyclicality, especially in net commodity importers. Revenue volatility in small states also results from terms-of-trade shocks attributable to a lack of diversification and narrow production bases. The elasticity of revenue to terms of trade, after controlling for GDP, is much higher in resource-rich small states than in comparators. Furthermore, revenue in small states depends on vulnerability to natural disasters. The IMF staff analysis suggests that a natural disaster that affects 1 percent of the population causes a drop in real revenue of 0.2 percentage point in small states and 0.4 percentage point in the Pacific islands small states. Further analysis of the small states of the Pacific points to a contraction in tax revenue of 0.2 percentage point of GDP in the year of the disaster, followed by a revenue rebound in the following year (Annex Figure 10.1.1). After controlling for GDP, the volatility of trade flows (including tourism) and remittances also affects revenue volatility. In Asia and Pacific small states, most of the volatility is caused by fishing license fees, which are independent of the economic cycle.

Figure 10.11Revenue Volatility across Different Groups in Small States

Sources: IMF World Economic Outlook database; and IMF staff estimates.

1 Volatility after excluding time trend in the underlying ratios to remove structural factors.

2 Excluding grants.

3 Excluding advanced economies.

The degree of revenue volatility differs across small states, with fragile states, commodity exporters, and microstates affected most. The volatility of tax revenue is highest among resource-rich countries (Guyana, the Solomon Islands, Suriname, Trinidad and Tobago) as a result of commodity price shocks, as well as uncertainty about the size and exhaustibility of resources. The volatility of nontax revenues is extremely high, especially in Asia and Pacific microstates that rely on fishing license fees, such as Kiribati and Tuvalu, where these fees represent about 50 percent of revenues. This is also true in such resource-rich countries as Bhutan, São Tomé and Príncipe, and Timor-Leste, owing to the volatility of royalties associated with natural resources.

Revenue volatility is also a potential source of vulnerability. High volatility may lead to significant output volatility and undermine overall fiscal performance in the absence of a stabilization fund (IMF 2012).

Addressing Procyclical Fiscal Policy

The combination of revenue volatility and current spending rigidities, compounded by the low access to finance of small states, has prevented expenditure smoothing over the business cycle and has thus fostered fiscal procyclicality (namely, spending went up together with revenues during upturns and vice versa during recessions; Figure 10.12). Revenue volatility has generally translated into spending volatility, especially capital spending. The IMF staff analysis suggests that revenue shortages have resulted in cuts to capital spending. Econometric results also confirm the procyclicality of capital spending (Annex Table 10.1.3).

Figure 10.12Procyclical Bias in Fiscal Policy in Small States

Sources: IMF, World Economic Outlook database; and IMF staff estimates.

Note: LICs = low-income countries. Bars in panel 2 show the change in the variables when revenue drops by at least 2 percent of GDP after removing the cyclical impact; all variables are corrected for GDP cycle. Panel 3 shows primary government spending.

1 The procyclical bias is measured by the difference between the bars within each group. For each country output gaps are estimated using Hodrick-Prescott filters.

Building Fiscal Buffers to Enhance Resilience: The Role of Fiscal Anchors

Policies that manage revenue volatility and avoid procyclical fiscal bias could foster resilience in small states. Given their vulnerability to shocks, enhancing resilience requires building adequate fiscal buffers for rainy-day countercyclical support and creating policy space for spending on infrastructure to boost potential output. Indeed, some small states have made progress in rebuilding fiscal buffers after the global financial crisis (Figures 10.13 and 10.14), but more than half still have less comfortable buffers (higher debt and lower fiscal balances) than before the crisis (Figure 10.15).

Figure 10.13Small States: Gross Public Debt

(Percent of GDP)

Sources: IMF, World Economic Outlook database; and IMF staff estimates.

Figure 10.14Small States: Overall Fiscal Balance

(Percent of GDP)

Source: IMF staff estimates.

Figure 10.15Fiscal Balance and Underlying Fiscal Balance, 2013

(Deviation from 2010–11; percentage points of GDP)

Source: IMF staff estimates.

Because of revenue volatility, small states’ headline fiscal balances do not always accurately reflect their underlying fiscal position. The improvement in the fiscal position of small states, defined by the change in the underlying fiscal balance, appears to be smaller than the change in the overall balance suggests in a quarter of the small states.

Strengthening fiscal frameworks by using fiscal anchors to insulate the budget from revenue volatility is essential. A country-specific fiscal anchor helps illustrate that fiscal policy reflects both short-term cyclical and medium-term sustainability goals. It also helps properly assess a country’s underlying fiscal position, which is sometimes masked by headline fiscal balances. Stronger fiscal frameworks will avoid fiscal procyclicality by saving windfall revenue during an “up” cycle and vice versa. The use of a fiscal anchor to smooth spending over the cycle would also go hand in hand with strengthening the medium-term orientation of fiscal policy, replacing the year-by-year formulation based on volatile and uncertain revenue.

The design of fiscal frameworks by using anchors that help manage revenue volatility and ensure debt sustainability in small states should be kept simple. Moreover, a fiscal-rule framework should set both a fiscal anchor target and an operational target. While the former is the final objective to preserve fiscal sustainability, the latter is an intermediate target under the direct control of governments, with a close link to debt dynamics. Since the final objective of the framework is to preserve fiscal sustainability, a natural anchor for expectations is the debt ratio, which creates an upper limit to repeated (cumulative) fiscal slippage. In addition to the anchor, the framework should include an operational target, which would be under the direct control of governments, while also having a close link to debt dynamics.

As IMF (2014c) reports, the choice of the operational target is more difficult and controversial. Public debt cannot play this role, as factors other than policy decisions affect public debt changes, including below-the-line operations and valuation effects. Available options include a revenue rule, an expenditure rule, a nominal balance, a structural balance target (in level or in first difference), or a combination of these options. Actual capacity constraint and, importantly, structural changes in the economy imply that meaningful, cyclically adjusted balances are difficult to calculate. In this context, the output gap is not only difficult to estimate, but is also erratic in nature. This is because it depends less on the dynamics of domestic economies and more on external and unpredictable developments (for example, trends in activity in trade partners, terms of trade, and commodity prices, including the recent drop in oil prices) given undiversified export bases. The underlying fiscal balance could be designed using a normal level of revenue (that is, backward-looking averages) or, for commodity exporters, by removing the direct and indirect effect of commodity revenue.4

Fiscal anchors are not a panacea. Moreover, they need to be accompanied by a more broad-based fiscal reform strategy. Political economy considerations suggest that moving away from a budget balance rule without strengthening fiscal institutions could create a fiscal deficit bias. While a country will find it easy to run a deficit during downturns, building fiscal buffers during upturns by saving revenue windfalls could be difficult because of political pressure to spend to meet large development and infrastructure needs. Appropriate fiscal institutions need to support fiscal framework reforms, including institutions that facilitate the formulation of long-term revenue forecasts, the implementation of quality public investment projects, and the sound management of rainy-day funds.

Policy Reform Options

Small states need to strengthen their fiscal frameworks to sustain economic growth. This requires an appropriate balance between fiscal buffers for rainy days and fiscal space for investment in infrastructure and human capital (see Box 10.2 for a quantification of the trade-off between building buffers and investing). Strengthening the fiscal framework is important for growth because it:

  • Enhances resilience by minimizing fiscal risks, which are particularly high in microstates and arise from volatile revenue and budget-spending rigidities.

  • Creates fiscal space for growth-enhancing and poverty-reducing investment, including infrastructure spending.

  • Builds fiscal buffers to enhance macroeconomic management and uses countercyclical spending during more difficult times.

  • Allows nonrenewable resource revenue in resource-rich small states to be used wisely and ensure long-term fiscal sustainability.

But strengthening fiscal frameworks is particularly challenging in small states. This is because of their budget rigidities, extreme revenue volatility, spending procyclicality, and limited capacity. Tackling these challenges thus requires a comprehensive macro and fiscal reform strategy, including spending and revenue reforms. This strategy should include several pillars:

  • Preserving strong fiscal fundamentals—Over the fiscal cycle, deficits should be kept low, on average, to avoid accumulating rising debt burdens. Low deficits and moderate debt burdens are correlated with stronger GDP growth.

  • Minimizing fiscal rigidity and lowering recurrent spending to create fiscal space for capital spending— Typical sources of rigidities are high spending on public wages, large entitlement programs for civil servants, and revenues earmarked for large capital projects. Reform of wage bills, public servants’ benefits, and revenue administration should thus be included in the fiscal package. Countries should also seek to deliver public goods and services at the lowest possible recurrent cost, avoiding the use of public resources to support loss-making, inefficient public sector enterprises. To this end, exploring opportunities to outsource service delivery to the private sector is warranted, where possible. This will create scope to finance growth-enhancing capital spending (see Figures 10.5 and 10.6).

  • Improving the spending mix toward investment in human and physical capital—This will require spending reforms in the form of spending reviews and medium-term expenditure frameworks. Their goal should be to reallocate resources toward priority spending, especially infrastructure investment, including climate-proofing infrastructure and strengthening health and education sectors. This will also improve the business environment and attract private investors from abroad.

  • Adopting budget and investment practices that can foster high returns on capital investments— Because resources for capital spending will remain tight, countries need to adopt investment practices that maximize value for money. This will involve identifying, prioritizing, and implementing public investment projects. At the same time, strengthening the medium-term orientation of fiscal policy by adopting a multiyear budget framework can help clarify which projects should be financed and over what timeframe. Developing a multiyear budget framework should also help, politically, to deal with spending pressures arising from large development needs. This could help build consensus on the appropriate sequencing of development projects and better calibrate the pace of development spending. Such a framework, however, needs to take into account capacity constraints, which is a pressing issue in small states.

  • Identifying resources to help weather revenue volatility—These could include contingency funds within the budget, sovereign wealth funds for resource-rich economies, and/or insurance policies. Contingency funds can also be used to manage shocks. Natural disaster funds or general budget contingency reserves can be used to save resources to deal with natural disasters. From a PFM perspective, access to these funds and reporting on their use should be clearly defined, and budget allocations transparent. The Solomon Islands’ National Transport Fund is a case in point.

  • Using fiscal anchors to help smooth spending and isolate budgets from revenue volatility—Where resources can be identified, budgets should allow for spending to be smoothed in the face of revenue shocks. In commodity-resource-rich countries, targeting the noncommodity fiscal balance and using sovereign wealth funds to enhance the management of natural resources will also ensure the long-term sustainable use of exhaustible resources. Rather than focusing on the current fiscal deficit, the budget should provide for spending in line with underlying revenues. The caveat is that countries will need to distinguish between temporary and more sustained revenue shocks. In the latter case, there may be no alternative to adjusting spending, and here the focus should be on the pace of adjustment and on achieving a balanced adjustment between recurrent and capital spending.

  • Strengthening domestic revenue mobilization to support the rebuilding of policy buffers— Mobilizing revenues by bolstering administration capacity and reforming the domestic tax system is also needed to increase fiscal space to meet critical development spending needs while improving the business environment. In practice, these reforms need to be tailored according to country circumstances. For example, realistically enforcing customs compliance in very large and scattered territories, as are many Pacific island countries, is extremely challenging and costly. There is also a need to focus on large taxpayers, who account for 70–80 percent of revenue, by creating a special unit in tax administration offices, while using a simplified tax system and simplified compliance rules for medium-sized and small taxpayers. Developing a proper mix of income and consumption taxation (value-added and sales tax) would raise additional revenues.5 Lower oil prices also offer an opportunity to reform energy subsidies and taxes in both oil exporters and importers. Oil-importing small states should use savings from the removal of energy subsidies to strengthen fiscal buffers or to increase public infrastructure if conditions allow.

  • Enhancing regional cooperation on nontax revenue to increase revenue mobilization—The small Pacific states need to strengthen regional economic, institutional, and technological networks to compensate for geographical isolation and dispersion and create a more attractive business environment for foreign investors. Key sectors for this are fisheries and information and communication technology. Adopting regional agreements and cooperative subregional measures to strengthen the bargaining power of license-issuing countries could improve fishing sector productivity. The Nauru agreement, a regional pact on fisheries among Kiribati, Marshall Islands, Micronesia, Nauru, Palau, Papua New Guinea, the Solomon Islands, and Tuvalu, is a success story in using regional cooperation to mobilize revenues (IMF 2014b).

These fiscal reforms need to be accompanied by measures to strengthen fiscal institutions and fiscal governance. The reform measures should aim at improving transparency (by enhancing budget planning, internal auditing on the use of public funds, monitoring, reporting, and evaluation systems to improve accountability), cash management, and project management capacity. Developing institutional frameworks will help better identify, quantify, monitor, and mitigate fiscal risks. And fiscal frameworks should be integrated with a debt management strategy to manage cash flows effectively and reduce sovereign financing risks. A successful case of this was the introduction in the Solomon Islands in May 2012 of a strategy to strengthen debt management and debt sustainability, which superseded the Honiara Club Agreement, which prevented the country from contracting external borrowing.

The IMF, for its part, has been assisting small states through capacity development in strengthening fiscal frameworks. This has involved both IMF headquarters and regional technical assistance centers providing technical assistance and training. In this respect, the work by the IMF Fiscal Affairs Department could be further leveraged to reduce the procyclicality of fiscal policy (through the appropriate design of fiscal rules, for example), create fiscal space (by energy subsidy reforms and revenue enhancing measures), and strengthen revenue and PFM.

Annex 10.1. Econometric Analysis

Determinants of Real per Capita GDP Growth

To assess the effects of fiscal policy on per capita output (Annex Table 10.1.1), we use dynamic panel regressions where real per capita GDP growth (that is, the dependent variable) is regressed on a fiscal balance indicator on the share of government capital spending over total public spending and on the ratio of public debt, as in Baldacci, Hillman, and Kojo (2004). The model controls for external conditions by including an indicator of trade openness. The signs and the significance of the model’s coefficients suggest that for a given amount of public spending, expanding the share of capital investment helps boost per capita growth but expanding the deficit does not.

The impact of capital spending on growth is stronger in Asia and Pacific small states than in other small states, consistent with their larger development needs. The model also suggests there is a nonlinear relationship between debt and growth in line with previous results (IMF 2012); that is, while low levels of debt are good for growth, high levels are not.

Determinants of Real Revenue

Separate dynamic panel regressions were run for different groups (small states, Pacific island small states, low-income countries, emerging markets, resource-rich small states, and non-resource-rich small states) to identify the variables that explain real revenue (Annex Table 10.1.2). The dependent variable (real revenue) is regressed on GDP (and its lag), weighted terms of trade (and its lag), a variable on natural disasters, lagged real revenues, and fishing license fees. Revenue shows strong procyclicality, especially in small states that are net commodity importers. And revenue procyclicality is a source of revenue volatility. Coefficients on real GDP growth variables higher than 1 suggest revenue procyclicality (that is, revenue is growing faster than GDP during upturns and slower than GDP during downturns). For small states, the sum of the coefficients on real GDP growth (current period and one period lagged)—a proxy for cyclical components of revenues—is equal to 1.7. After controlling for GDP, revenue depends on terms-of-trade shocks, especially in resource-rich small states. Natural disasters also raise revenue volatility. The IMF staff analysis suggests that a natural disaster that affects 1 percent of the population causes a drop in real revenue of 0.2 percentage point.

Annex Table 10.1.1Determinants of Real per Capita GDP Growth
Asia and Pacific Small StatesAfrican Small StatesCaribbean Small StatesSmall StatesEmerging Market and Developing Economies1
Overall fiscal-balance-to-GDP ratio0.227***0.1350.06640.226***−0.0237
Ratio of government capital expenditure to total government expenditure0.124***0.154***0.02990.0878***0.0160
Debt-to-GDP ratio (lagged)0.249***−0.001470.001690.0380**−0.00466
Lag (debt-to-GDP ratio)^2−0.00214***−4.79e-05−0.000103−0.000218***−2.26e-05
Trade openness0.0384***0.001210.006200.0274***0.0422***
World GDP growth, percent0.610***0.490*0.849***0.641***0.697***
Five-year lag of log (real GDP per capita, purchasing power parity)0.7201.739*−1.503**0.535*−0.0982
Constant−19.31*−17.41**11.95−10.90***4.204*
Observations192771944821,325
Number of countries1361233102
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. * p < 0.1; ** p < 0.05; *** p < 0.01.1 Excludes small states.
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. * p < 0.1; ** p < 0.05; *** p < 0.01.1 Excludes small states.
Annex Table 10.1.2Determinants of Real Revenue(Year-over-year percent change)
Small StatesPacific Island Small States 1Low-Income CountriesEmerging MarketsResource-Rich Small StatesNon-Resource-Rich Small States
Real GDP growth1.093***1.672***1.622***1.41***0.933***1.249***
Real GDP growth (lagged)0.607*0.5680.236−0.1240.5120.556*
Weighted terms-of-trade growth0.390**0.659**0.468***0.821**1.401**0.120**
Weighted terms-of-trade growth (lagged)0.2270.3520.130−0.1800.2600.136
Intensity of natural disasters (lagged)−0.248**−0.429***0.039−0.189−0.294−0.239**
Real revenue growth (lagged)−0.410−0.375−0.1810.024−0.237−0.545
Fishing license fees0.206***
Constant0.009−1.667−1.223−0.8952.498−0.684
Observations59192730745100466
Number of countries3364949627
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. Combined coefficients higher than 1 on real GDP growth and lagged GDP growth imply revenue procyclicality.* p < 0.1; ** p < 0.05; *** p < 0.01.1 Includes countries dependent on fishing license fees.
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. Combined coefficients higher than 1 on real GDP growth and lagged GDP growth imply revenue procyclicality.* p < 0.1; ** p < 0.05; *** p < 0.01.1 Includes countries dependent on fishing license fees.

Impact of Natural Disasters on Tax Revenue

The IMF staff analysis in Chapter 5, using a panel vector autoregression, suggests that a natural disaster that affects 1 percent of the population in Pacific island small states leads to a contraction in tax revenue of 0.2 percentage point of GDP in the year of the disaster, followed by a revenue rebound the next year (Annex Figure 10.1.1). The model focuses on the impact of natural disasters on real GDP and fiscal variables. The specification includes the following variables: natural disaster intensity, real GDP growth, change in total government expenditure as a percent of GDP, change in tax revenue as a percent of GDP, and change in the overall fiscal balance as a percent of GDP. The variable on natural disaster intensity is measured by the number of fatalities and others hurt by the disaster as a share of total population, in line with Fomby, Ikeda, and Loayza (2013).

Annex Figure 10.1.1Response of Tax Revenue to Natural Disasters

(Percentage points of GDP)

Source: IMF staff estimates.

Annex Table 10.1.3Degree of Spending Procyclicality
Real Current Government Expenditure (Year-over-Year Percent Change)Real Capital Government Expenditure (Year-over-Year Percent Change)
Small StatesAfrican small StatesAsia and Pacific Small StatesCaribbean Small StatesLow-Income CountriesEmerging MarketsSmall StatesAfrican Small StatesAsia and Pacific Small StatesCaribbean Small StatesLow-Income CountriesEmerging Markets
Real GDP growth0.523***0.7560.623**0.2230.633***0.413***2.346***2.5602.058**2.412**2.634***1.476***
Constant1.522**0.6830.9222.528**1.7511.949**−5.323**−6.682−6.921*−3.474−6.342−2.120
Observations6791262642538301,8726791262642538301,872
Number of countries336131244101336131244101
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. Spending is procyclical if the coefficient on real GDP growth is higher than 1.*p <.10; **p <.05;***p <.01.
Source: IMF staff estimates.Note: Panel regressions, 1990–2013. Spending is procyclical if the coefficient on real GDP growth is higher than 1.*p <.10; **p <.05;***p <.01.

Degree of Spending Procyclicality

This model assesses the degree of spending procyclicality; that is, capital spending increasing during good times and declining during recessions (Annex Table 10.1.3). The change in real government spending is regressed on changes in real growth. The elasticity of real current government spending is lower than 1, suggesting that current spending is not procyclical. The elasticity of capital is much.

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Hereafter simply referred to as small states.

Specifically, an episode of expenditure expansion is defined as an increment in the ratio of government expenditure to GDP for at least two consecutive years. Government expansion is assumed to be led by capital expenditure if capital expenditure explains at least two-thirds of the government expenditure growth.

Ongoing debate on the impact of public spending policies on growth shows that the growth dividend of public capital spending also hinges on the return on investment (see Box 10.2), the sources of financing (Gemmell, Misch, and Moreno-Dodson 2012; Romp and de Haan 2007), and the quality of the investment processes in project selection and implementation (Gupta and others 2014).

The indirect component of resource revenue is estimated by running a regression of the nonresource revenue on the resource revenue. This provides an estimation of the comovements of the two components of revenues. The indirect effect of resource revenue is estimated by projecting the nonresource revenue based on the resource revenue.

Kiribati has experienced a significant improvement in tax collection with the introduction of a withholding tax at source in March 2009. It also introduced value-added tax in 2014.

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