Chapter

II. The Creation of Fiscal Space for Priority Spending: Case Studies in Sub-Saharan Africa

Author(s):
International Monetary Fund. African Dept.
Published Date:
October 2007
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Many sub-Saharan African countries have been successful in their progress toward stabilizing their economies, thereby easing constraints on fiscal policy. The success in macroeconomic stabilization is reflected in strong growth, single-digit inflation, sustainable external current accounts, and high reserves, as outlined in Chapter 1 (Table 1.1). Debt relief has substantially improved debt sustainability. The G-7 countries have also promised to scale up aid to sub-Saharan Africa. Consequently, there is now less need to gear fiscal policy toward addressing macroeconomic imbalances.

Numerous governments are already reorienting their fiscal policies toward growth and poverty reduction. Revenue reforms have sought to expand tax bases while reducing rates to encourage private sector investment and consumption. Public spending is being geared toward strengthening social safety nets and improving education and health care services.

In the new environment, donors and nongovernmental organizations are now debating the role of “fiscal space” to help sub-Saharan African countries make greater progress toward the MDGs. The immediate question is how much room the easing of macroeconomic and debt burden constraints provides in the short run for fiscal expansion. However, there is a broader debate about which medium-term fiscal strategy best recognizes the spending needs of these countries while respecting macroeconomic and fiscal sustainability constraints.11 Respecting these constraints is important to avoid a repetition of past cycles of unsustainable spending programs, high inflation, and borrowing.

What is meant by fiscal space? As defined by Heller (2005, p. 3), fiscal space is “the availability of budgetary room that allows a government to provide resources for a desired purpose without any prejudice to the sustainability of a government’s financial position.” The issues that arise in creating and using fiscal space are not new; governments have always had to judge how much scope there is to increase expenditure and how to finance and sustain their operations over time. However, the concept of fiscal space brings fiscal policy choices and their trade-offs into sharper focus by linking them to the availability of resources and by embedding fiscal policy in a medium-term context to ensure fiscal sustainability.

There are many sources and uses of fiscal space. Countries can (1) mobilize domestic revenue;(2) borrow from domestic and external sources; (3) secure external grants; (4) reprioritize expenditures; and (5) make spending more efficient. While fiscal space is often used to increase spending, it can also be used for other purposes, such as repaying debt.

In sub-Saharan Africa, the mobilization of domestic revenue, complemented by higher grant inflows, has been a significant source of fiscal space (Figures 2.1 and 2.2). This space has been used to increase expenditures, including for health and education (Figure 2.3). In the last five years many countries have also used fiscal space to reduce deficits and thus lower borrowing requirements and make their debt more sustainable (Figure 2.4).

Figure 2.1.Median Revenue-to-GDP Ratio for Selected Groups of African Countries

Source: IMF staff estimates.

1 Excluding South Africa.

2 Countries that have reached the decision point for the enhanced HIPC Initiative.

Figure 2.2.Median Grants-to-GDP Ratio for Selected Groups of African Countries

Source: IMF staff estimates.

1 Excluding South Africa.

2 Countries that have reached the decision point for the enhanced HIPC Initiative.

Figure 2.3.Median Expenditures-to-GDP Ratio for Selected Groups of African Countries

Source: IMF staff estimates.

1 Excluding South Africa.

2 Countries that have reached the decision point for the enhanced HIPC Initiative

Figure 2.4.Median Overall Deficit–to-GDP Ratio for Selected Groups of African Countries

(Including grants)

Source: IMF staff estimates.

1 Excluding South Africa.

2 Countries that have reached the decision point for the enhanced HIPC Initiative.

The experiences of Ghana, Malawi, Rwanda, Tanzania, and Uganda demonstrate how fiscal space applies to diverse circumstances, challenges, and trade-offs. A notion that often underlies the debate on fiscal space is that managing the macroeconomic and fiscal implications of scaled-up aid inflows is becoming the main challenge for sub-Saharan African low-income countries, but the five countries considered here suggest that the range of challenges is much wider. For example, at least two of the five must deal with declining rather than increasing aid inflows. On the other hand, the build-up of unsustainable debt that has been an issue in the past does not seem to be a problem for the countries considered here. Most have reduced their fiscal deficits, which lowers borrowing requirements, and have integrated debt sustainability analysis (DSA) into their policymaking.

The five countries chosen mirror the experience in sub-Saharan Africa. They have created substantial fiscal space over the past 10 years, mostly by mobilizing domestic revenue as well as attracting external grants, and have increased expenditures, particularly on poverty reduction (Table 2.1). Yet there are substantial differences among them:

  • Ghana, Tanzania, and Uganda have all been successful in maintaining macroeconomic stability and are far along in their reform efforts, but aid inflows to Ghana and Uganda will possibly decline. In response, Uganda intends to raise domestic revenues—something also central to Tanzania’s fiscal strategy—and Ghana is considering external borrowing on nonconcessional terms. Reprioritizing and enhancing the efficiency of expenditures will also be important.

  • Rwanda, which has significantly increased its domestic revenues in recent years, intends to finance its medium-term development strategy mostly through scaled-up aid, especially grants.

  • Malawi’s economy is not yet stabilized and it must reduce its domestic debt burden. Freeing up fiscal space by lowering domestic interest payments, while simultaneously protecting social spending and increasing public investment, is a major priority.

Table 2.1.Fiscal Space Indicators for Selected Countries, Changes, 2000–06(Percent of GDP)
GhanaMalawi1RwandaTanzaniaUganda2
Source of fiscal space11.03.38.37.8-3.0
Domestic contribution3.4-1.15.33.70.2
Revenues3.91.55.42.81.8
Domestic interest payments32.82.7-0.30.2-0.5
Domestic financing (net)-3.2-5.30.20.7-1.1
External contribution7.54.43.04.0-3.3
Grants3.12.82.51.5-1.3
External financing (net)44.41.60.42.5-2.0
Use of fiscal space11.03.38.37.8-3.0
Wages4.40.5-0.70.20.7
Other current spending3.64.06.38.10.7
Development expenditures3.1-1.22.7-0.4-4.4
Memorandum item:
Pro-poor spending55.93.86.76.81.6
Source: IMF staff calculations.

The experience of these countries suggests a few lessons that are salient for other sub-Saharan African countries:

  • Domestic revenue mobilization has clear advantages as a source of fiscal space for countries whose revenue share in GDP is low, but the required institutional reforms are typically difficult and time-consuming to implement.

  • Improving the efficiency of expenditures also depends on substantial institution-building; there has been progress, but a large reform agenda remains for many countries.

  • Some countries are formulating strategies to mitigate the impact of aid inflows on external competitiveness by frontloading productivity-enhancing expenditures; such an approach is preferable to monetary policy interventions that attempt to prevent a real appreciation of the currency, especially since some real appreciation is desirable to stimulate the production of nontradable goods and services.

  • More needs to be done to anchor fiscal policy decisions in a medium-term framework; only a few countries have sophisticated frameworks that provide a link to government objectives—e.g., PRSP priorities—and include detailed costing of sector-specific programs while accounting for recurrent cost implications.

Experience with Sources of Fiscal Space

Increasing domestic revenue is a major part of the fiscal strategy for Tanzania, Uganda, and Rwanda. At the outset, the revenue-to-GDP ratio was relatively low for all three countries—less than 15 percent of GDP.12 The revenue effort in these countries is underpinned by reform of tax administration and policies:

  • Tax administration reform usually focuses on functions rather than types of tax. It emphasizes upgrading skill and audit techniques, creating large-taxpayer units, and amending the laws related to control and compliance. However, building the necessary institutions takes considerable time.

  • Tax policy measures are typically directed to simplifying the tax system and broadening the base, for example by introducing value-added taxes (VATs). A potentially regressive tax like the VAT can have an adverse social impact, but this can be offset, for example, through selective and limited exemptions, such as those on basic food items. A tax policy Poverty and Social Impact Analysis (PSIA) is a useful tool to assess these implications (see Box 2.1).

Collecting more revenue lessens dependence on donors (an important factor for Uganda’s authorities) and avoids Dutch disease effects from external inflows (see below). However, it implies that resources the private sector might otherwise use to support consumption and investment are reallocated to the public sector. The benefits of the public spending this affords must be balanced against the loss to the private sector. Moreover, taxes often have distortionary effects, even though policy measures that broaden the tax base can make the tax system more efficient. Limited monetization and the prevalence of subsistence agriculture in many sub-Saharan African countries affect how much tax collections can add to fiscal space.

Domestic borrowing as a source of fiscal space has significant drawbacks and should only be undertaken carefully with due regard for long-term fiscal sustainability. Like higher taxes, it takes resources from the private sector, potentially crowding out private investment. It is often very expensive, with interest rates far exceeding those on concessional external loans. Also, the scarcity of private domestic savings that is common in very poor countries means that substantial recourse to domestic borrowing can precipitate sharp increases in interest rates, causing a sizable fiscal burden. This happened in Malawi, which is now attempting through fiscal consolidation to lower domestic debt to reduce its interest payments, thus freeing up fiscal space for the future.

Box 2.1.The Poverty and Social Impact of Increasing Fiscal Space through Revenue Collection

Though collecting more taxes can expand fiscal space, the distributional consequences of such a policy can undermine progress toward the MDGs. Good tax policy is guided by the general principles of neutrality, equity, simplicity, and efficiency (Tanzi and Zee, 2001). The possibility that taxation may increase income inequality generally declines as the ratio of direct to indirect taxes increases (Chu, Davoodi, and Gupta, 2000).

A tax policy Poverty and Social Impact Analysis (PSIA) conducted in Uganda showed that a 1 percent increase in VAT would be mildly regressive and would not significantly increase revenue. Increasing excise taxes on petroleum products was distributionally neutral, and allocating the revenue to a social safety net would protect the poor against future VAT increases.

Tanzania simplified local government taxation and abolished both the flat rate development levy and nuisance taxes, which made the system more progressive: the tax burden on richer households increased by 14 percent and the burden on poorer households fell by about 33 percent.

Though income distribution in industrial countries has been improved through taxation and transfers, these mechanisms have not been as effective in developing countries. This is largely due to poor targeting of expenditures and the low share devoted to social areas (Gupta, 2003). In Uganda, mitigation measures were designed to promote health and education, to improve both investment in human capital for growth and the welfare of the population. In Tanzania, the increased disposable income of the poor gave them more flexibility in purchasing goods and services. However, while there was no overall gain in revenue in urban areas, rural councils lost revenue and became more reliant on central government transfers.

Strengthening the social contract between citizens and government is critical to good taxation policy (World Bank, 2006; Moore and Schneider, 2004). It increases transparency and makes clear the links between taxes paid and services delivered. The Tanzanian PSIA, which included consultations with both citizens and businesses, identified a tolerance for increasing progressive taxation, specifically property taxes, to fund public social services like education.

Note: This box was prepared by Kirsty Mason.

Debt relief in many sub-Saharan African countries has opened fiscal space for external borrowing. The concessional external loans that are available to many low-income countries are less expensive than domestic borrowing and easier to mobilize than domestic revenue. Unlike revenues or domestic borrowing, these loans provide foreign exchange to finance the importing of investment and consumption goods, thereby facilitating a widening of the current account deficit, which increases the resource envelope available to the economy. Nevertheless, due regard has to be paid to debt sustainability. In Ghana the government is considering borrowing externally on nonconcessional terms to fund an investment program for which aid financing has not materialized. To mitigate the debt sustainability risks, Ghana’s plans have been incorporated into a DSA, and keeping debt sustainable is a fiscal anchor, as it also is for Rwanda.

Grants, like external borrowing, mobilize external resources but avoid the debt service burden and debt sustainability risks associated with borrowing. They are, however, typically more difficult to obtain than loans. Except for debt relief grants, the timing and magnitude of such disbursements can be uncertain, making medium-term fiscal planning more difficult. In Rwanda, for example, the authorities intend to finance the country’s medium-term development strategy mostly with grants, but they have yet to receive firm commitments. Debt service savings as a result of HIPC Initiative and MDRI debt relief grants have been substantial (Table 2.2), but the savings will decline over time, which puts a premium on the predictability of regular grants.

Table 2.2.Debt Service–to-GDP Ratios for Selected Countries, 2000–06
2000 Est.2002 Est.2004 Est.2005 Est.2006 Proj.Change 2000-06
Ghana10.84.32.21.50.7-10.1
Malawi5.92.93.63.33.7-2.2
Rwanda2.10.91.00.80.2-1.9
Tanzania1.71.01.71.40.2-1.5
Uganda1.81.11.51.40.7-1.1
Sources: Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI)—Status of Implementation, August 21, 2006.

Reliance on grants and external borrowing may cause the real exchange rate to appreciate. This is in part simply the converse of the benefit they bring. With imports meeting part of domestic demand for tradable goods, it is often desirable to reallocate production factors from the tradable to the nontradable sector to meet the demand for services (like those of teachers or nurses) that arises from scaled-up expenditures. To bring about such a reallocation, a real appreciation is often required. The disadvantage is that an appreciation tends to undermine competitiveness, particularly in export sectors. There is a potential cost (Dutch disease) if exporting plays a special role in promoting productivity growth, which should be balanced against the benefits of aid-financed spending.13 Rwanda’s development strategy is to address these concerns by investing in capacity-building and infrastructure; that should enhance economic productivity and increase the amount of aid that can be absorbed without jeopardizing competitiveness.

Reprioritizing expenditures, which creates fiscal space by reducing spending in lower-priority areas, is a policy option when there is little room to increase resources generally. In both Uganda and Ghana, plans to mobilize resources through taxes and external borrowing will only keep the resource envelope steady as donor support declines. This means that to accomplish the public investment programs both countries envision, they must reduce spending on lower-priority programs. The situation is similar in Malawi, where resources are projected to be relatively flat for the foreseeable future. In Rwanda, reduced military and other low-priority spending has created space for priority spending.

Making current spending more efficient is inherently desirable and avoids many of the drawbacks of other sources of fiscal space, but the institutional reforms required take time, in part because they often have political and distributional implications. Periodic tracking surveys and public expenditure reviews like those recently undertaken in Malawi can help identify potential efficiency gains. These surveys often reveal “ghost workers,” excessive administrative costs, and other kinds of inefficiencies. That is why many countries make strengthening PFM a priority. Tanzania has been particularly successful in this respect; its PFM system received the highest rating of that in 26 HIPC countries. Civil service reform can also make delivery of public services more efficient, something Ghana and Rwanda are planning. A more efficient public sector can also unlock additional donor support, as it has done in Tanzania.

Experience with the Use of Fiscal Space

Fiscal space is often used to increase poverty-reducing public spending. This has been observed in all five countries. As for nonexpenditure uses of fiscal space, reducing dependence on donors over time and easing exchange rate appreciation pressures because of external inflows have been important considerations for Rwanda and Uganda.

Trade-offs among government priorities must be taken into account when creating and using fiscal space. For example, many governments are committed to reaching the MDGs but their absorptive capacity limits the amount of external aid they can effectively deploy. Policymakers consequently have to prioritize MDG objectives; they may have to choose, for example, between infrastructure spending to promote growth and social spending to advance non-income-related human development. A useful tool for assessing the relationship between MDG objectives and the macroeconomic impact of scaled-up aid is the World Bank’s Maquette for MDG Simulations (MAMS) model. This is a general equilibrium model that links sectoral spending plans to growth and real exchange rate movements; it incorporates macroeconomic feedback effects and absorptive capacity constraints. Applied recently to Ghana, it showed that a significant scaling-up of external finance and improvements in the efficiency of spending would be necessary to meet the MDGs, and productivity would have to be higher to mitigate Dutch disease effects.

Planning for the Medium Term in Theory and Practice

Decisions about the use of fiscal space are best made over the medium term to ensure that consequences for macroeconomic stability and fiscal sustainability are explicitly taken into account. Different medium-term frameworks have different complexities:

  • Medium-term fiscal frameworks integrate projection of macroeconomic variables with programming of fiscal policy aggregates, typically over 5 to 20 years. This is the most basic approach to medium-term analysis and is implemented by most countries, often as part of their DSAs. Even at the aggregate level, it is possible to model both the effect of public investment on growth and the effect of growth on future revenues to capture the interdependence among uses and sources of fiscal space.

  • Medium-term budgetary frameworks and medium-term expenditure frameworks extend this approach to the sectoral level. Once the total spending budget has been set by a medium-term fiscal framework, a medium-term budgetary framework can be used to allocate spending by sector, informed, for example, by PRSP priorities and sectoral analysis. A medium-term expenditure framework extends the analysis further with detailed costing of specific sector programs, setting priorities within sectors, and accounting for recurrent cost implications.

In practice, implementing fully fledged medium-term expenditure frameworks is so challenging that only a few countries have done so. Uganda has moved the farthest; Tanzania, Ghana, and Rwanda have made good progress. Part of the challenge is setting up detailed sectoral plans and then costing them, which calls for substantial capacity in line ministries. Integrating medium-term expenditure frameworks into the annual budget process to ensure that medium-term expenditure framework allocations are reflected in actual budgets is also difficult because it often requires fundamental changes to the budget process.

Country Case Studies

Ghana: Fiscal Space through Nonconcessional Borrowing14

Ghana needs fiscal space to finance public investment to raise its growth potential and help it meet the objectives of the Ghana Growth and Poverty Reduction Strategy and the MDGs. The country should meet the poverty MDG goal well before 2015, but preliminary results from the MAMS show that, though it may deliver on some other MDGs, it will fall short on others unless there is a major scaling up of external resources. In 2006 the government developed an ambitious public investment plan for upgrading infrastructure—energy, utilities, and transport. When the plan was incorporated into the macroeconomic framework, the resulting resource gap was about 3 percent of GDP for 2007–11. The government tried unsuccessfully to secure additional donor resources to finance the gap.

Because aid has not increased, the investment plan was pared down to top-priority high-return projects, and the government decided to access the international capital markets. A capital markets committee appointed to vet the projects drew up a financing plan based on savings from capital budget reprioritizations, domestic borrowing, public-private partnerships, and nonconcessional borrowing. Current plans are for nonconcessional borrowing of about US$700 million over the next three years (equivalent to 1.4 percent of GDP annually).

Nonconcessional borrowing will not open up significant new fiscal space, but it will allow Ghana to maintain historically average levels of external financing. Total donor support—budget grants and project and program loans—peaked at about 9 percent of GDP in 2004 but has since fallen; donor commitments suggest that concessional flows should be about 7 percent of GDP a year through 2009 (Table 2.3). Thus, nonconcessional borrowing would restore external financing to the historical average of 8–9 percent of GDP (Figure 2.5). Total government expenditure ratios are expected to hold steady after 2007.

Table 2.3.Ghana: Sources and Uses of Fiscal Space(Percent of GDP)
2004–0620072008200920102011Change
AverageProj.Proj.Proj.Proj.Proj.2007–11
Source of fiscal space29.531.729.129.329.029.1-2.6
Domestic contribution21.521.421.222.121.722.61.1
Revenues23.122.222.422.422.522.70.5
Domestic interest payments-2.8-2.0-1.9-1.7-1.6-1.50.6
Domestic financing (net)1.31.20.71.40.71.30.1
External contribution8.010.37.97.27.36.5-3.8
Grants5.65.13.43.53.53.4-1.6
External financing (net)2.35.34.53.63.83.1-2.1
Use of fiscal space29.531.729.129.329.029.1-2.6
Wages8.99.49.49.49.49.40.0
Other current spending8.38.77.27.27.17.3-1.4
Development expenditures12.213.612.612.712.512.4-1.2
Memorandum item:
Pro-poor spending8.910.410.610.610.610.60.2
Source: IMF staff calculations.

Figure 2.5.Ghana: Total Official External Financing, 2005–09

(Percent of GDP)

Sources: Ghanaian authorities; and IMF staff estimates.

There is limited if any scope to increase fiscal space through other sources. Ghana tried unsuccessfully, and continues to try, to garner additional aid from emerging creditors like China and India. To mobilize more domestic revenue, Ghana has in the last decade introduced a VAT, reformed the petroleum tax, and rationalized the income tax; its tax revenue–to-GDP ratio is now above the average for sub-Saharan African countries. Although there are plans to streamline tax administration and broaden the income tax base, large increases in the domestic revenue–to-GDP ratio are neither feasible nor desirable. As the authorities intended, domestic debt has been reduced in recent years. While there is substantial investor interest in longer-term government bonds—a recent oversubscribed 5-year bond was largely taken up by foreign investors—the scope for further domestic borrowing would need to be carefully evaluated after the sustainability of public debt is analyzed.

Keeping debt sustainable is an important policy goal for the authorities, following massive HIPC and MDRI debt relief. The government is committed to making external borrowing decisions in the context of the DSA and moving toward using total debt (external and domestic) as a new fiscal anchor. The most recent joint IMF–World Bank DSA15 shows that even after incorporating the planned nonconcessional borrowing, the risks to Ghana’s debt sustainability are moderate, and even close to low. Alternative scenarios with lower growth and higher borrowing showed higher risks, however, so it will be important for the authorities to choose quality projects and keep refining their policies to spur exports and growth. Recognizing the challenges of nonconcessional borrowing, the authorities also realize they must strengthen the institutional framework for selecting projects and managing debt; a value-for-money unit is being established, and the IMF is providing technical assistance on debt management.

Ensuring that resources from all sources are used efficiently to help accelerate growth could create more fiscal space. Initiatives such as the value-for-money unit and public expenditure tracking surveys with continuing PFM and civil service reforms will undoubtedly help make public spending more efficient. Improvements in fiscal reporting, treasury reform, and deployment of a new computerized payroll management system are already yielding tangible results. These efficiencies, with projected higher growth, could open up fiscal space.

Ghana faces a number of challenges in its strategy to accelerate growth and meet the MDGs. Maintaining macroeconomic stability and avoiding overheating will be a priority. This may require a more active role for monetary policy at a time of high fiscal spending. The authorities’ strategy is initially public sector led, starting with large infrastructure projects to remove supply bottlenecks. While this is fitting, it will be important to avoid crowding out of the private sector by involving it in public-private partnerships, continuing measures to improve the business environment, investing in human resources, and strengthening economic governance. Another challenge will be to assess trade-offs between different mixes of infrastructure and social sector spending. The World Bank’s MAMS model is a useful tool for MDG costing and assessing these trade-offs and the macroeconomic impact of scaled-up aid or other resources to meet the MDGs. Simulations for Ghana suggest that the poverty and other key MDGs could be met by a combination of large scaling-up of external resources and improvements in efficiency in the use of these resources, but that further productivity growth would be needed to mitigate potential Dutch disease pressures.

Malawi—Macroeconomic Stabilization and the Creation of Fiscal Space16

Malawi’s fiscal space shrank in 1999/2000 and 2003/04 as the macroeconomic situation rapidly deteriorated, driven by fiscal excess and external shocks. 17 Fiscal slippages occurred principally because budgets were not carefully prepared and executed, parastatals were repeatedly bailed out, and there were external weather shocks. As a result of poor fiscal management, some external budgetary support was withdrawn. When the government resorted to domestic financing, interest rates and inflation both rose. This set up a vicious cycle of ever-greater recourse to domestic financing, rising interest rates, widening fiscal deficits, and worsening public debt dynamics. By 2003/04, domestic debt had increased to 18 percent of GDP from 6½ percent in 1999/2000, and the interest on it was equivalent to 6½ percent of GDP (nearly one-third of primary government expenditures). External financing dropped to 3½ percent of GDP in 2002/03 from 10 percent in 1999/2000. Fiscal space shrank to 23½ percent of GDP in 2003/04 from 27 percent in 1999/2000.

In mid-2004 the authorities embarked on an ambitious, and so far successful, program to restore macroeconomic stability. Fiscal discipline became stricter and fiscal performance improved, despite a severe food crisis in 2005. As a result, domestic financing needs decreased, bringing about a reduction in the domestic debt ratio (from 18 percent of GDP in 2003/04 to 14½ percent in 2005/06), inflation, and real interest rates.

Macroeconomic stabilization expanded fiscal space by lowering the interest rate bill and helping to mobilize external support. Interest payments on domestic debt declined by 2 percentage points of GDP between 2003/04 and 2005/06. The restoration of macroeconomic stability, as well as an adverse weather shock in 2005/06, encouraged donor support, which increased by 4½ percentage points of GDP. Exogenous factors—a rebound in tobacco production in 2004 and bumper crops in 2006—provided additional support by boosting economic activity and revenues. As a result, despite significantly less domestic borrowing (by 5½ percent of GDP) fiscal space expanded by over 3 percentage points of GDP, and pro-poor expenditures grew by the same amount (Table 2.4). Malawi reached the HIPC completion point in August 2006 and has since qualified for the MDRI.

Table 2.4.Malawi: Sources and Uses of Fiscal Space(Percent of GDP)
Change
1999/002000/012001/022002/032003/042004/052005/062004–06
Source of fiscal space26.929.125.422.523.324.826.63.3
Domestic contribution16.717.020.018.915.414.814.2-1.1
Revenues16.918.817.014.416.418.217.91.5
Domestic interest payments-2.3-3.0-3.9-4.0-6.6-5.3-3.92.7
Domestic financing (net)2.11.26.98.55.61.90.2-5.3
External contribution10.212.15.43.67.910.012.44.4
Grants5.47.24.64.17.77.310.62.8
External financing (net)4.84.90.8-0.50.22.71.81.6
Use of fiscal space26.929.125.422.523.324.826.63.3
Wages4.75.26.85.04.75.55.30.5
Other current spending11.713.811.412.210.511.414.54.0
Development expenditures10.410.17.25.48.08.06.8-1.2
Memorandum item:
Pro-poor spending3.35.44.04.46.58.13.8
Source: IMF staff calculations.

Nevertheless, macroeconomic vulnerabilities persist. The real interest rate on government borrowing—estimated at over 7 percent—is high; given the still-high level of domestic debt, interest payments constitute a sizable part of the national budget. Although the nominal exchange rate has recently been fairly stable against the U.S. dollar, gross foreign exchange reserves at the Reserve Bank of Malawi were only 1½ months of imports at year-end 2006, so the country may be vulnerable to external shocks.

In the Malawi Growth and Development Strategy (MGDS), the medium-term fiscal goal is to maintain fiscal discipline and balance development and social spending. One objective is to gradually bring down the domestic debt–to-GDP ratio. The expenditure envelope in the MGDS is also shaped by the projected stable revenue-to-GDP ratio and the slightly declining (albeit from a high level) grants-to-GDP ratio. The authorities plan to improve intersectoral allocation of resources by balancing progrowth expenditures (agriculture and food security, irrigation and water development, transport infrastructure development, energy generation and supply, rural development) and social spending (prevention and management of nutrition disorders and of HIV and AIDS). Better budget and payroll management and intrasectoral spending efficiency can also effectively create fiscal space. The recent World Bank Public Expenditure Review identifies sizable potential efficiency gains in spending on education, health, nutrition, and infrastructure.

The major fiscal adjustment envisaged would help Malawi reduce its domestic debt. It would lessen vulnerabilities, create more fiscal space as the interest bill is lowered, and facilitate private sector development. Though the strategy requires Malawi to postpone some development and social spending, it appears optimal:

  • Lower debt would shield the authorities from external shocks. Given the shallow domestic financial market and limited access to foreign borrowing, the government would have trouble mobilizing financing if there were a weather or external financing shock. Reducing debt would allow it to build a buffer by facilitating accumulation of foreign reserves.

  • The reduction in net government borrowing may further reduce interest rates by lowering the risk premium. Sustaining macroeconomic stability would also be a positive signal to donors, ensuring a more predictable aid flow.

  • Measured scaling up of expenditures may help to improve their quality. The World Bank Public Expenditure Review finds that improving the quality of public spending is critical to accelerate growth and progress toward the MDGs.

  • Lower interest rates are likely to crowd in private sector investments.

Improving efficiency by strengthening PFM is also a priority. Malawi has been systematically improving budget execution and management generally. The government recently prepared a comprehensive PFM action plan that ties together and (importantly) prioritizes PFM needs. Current reforms aim to improve the budget process so that the government can reliably implement its fiscal policies. The next step in improving PFM involves more effective strategic budgeting, to which attention is now turning.

Rwanda: Creating Fiscal Space for Priority Spending18

In 2000–06 Rwanda successfully created fiscal space (9.1 percent of GDP) by doing the following:

  • Increasing the revenue-to-GDP ratio from 9.7 percent to 15.1 percent by changing tax policy and improving tax administration, particularly by opening the large taxpayer office.

  • Curtailing nonpriority expenditures, such as military spending (1.2 percent of GDP), and reallocating and increasing resources to peacekeeping efforts in Sudan and to essential services. The latter includes demobilization of rebel soldiers, supporting genocide survivors, prison food supplies, and rehabilitation.

The result was a near-threefold increase in pro-poor spending, from 4 percent of GDP in 2000 to 11 percent of GDP in 2006, and a better alignment of nonpriority spending toward supporting social services (Table 2.5). Because Rwanda still needs more fiscal space to address its severe infrastructure gap, increase agricultural yields, and advance toward the MDGs, the authorities plan to do the following:

  • Utilize external financing in the short to medium term, because there is limited scope for a higher tax effort in the short term (Figure 2.6a). Prospects for a scaling up of aid through grants are encouraging; however, the timing and magnitude are uncertain. To maintain debt sustainability—Rwanda is currently rated at high risk of debt distress by the joint Bank-Fund debt sustainability framework—financing should come mostly in the form of grants.

  • Gradually increase the revenue effort over the long term (Figure 2.6b). The authorities expect the tax base to widen as the economy grows and becomes increasingly monetized. This would be important for Rwanda to finance its own development and reduce its dependence on aid to cover current spending.

  • Reform the civil service and PFM. The authorities recognize that such efforts are important to address capacity constraints, particularly in local government, improve efficiency, and ensure that funds are used for their intended purposes.

Table 2.5.Rwanda: Sources and Uses of Fiscal Space(Percent of GDP)
Change
20002001200220032004200520062000-06
Source of fiscal space18.520.322.122.925.427.626.88.3
Domestic contribution7.97.311.913.39.711.513.25.3
Revenues9.711.412.313.513.915.115.15.4
Domestic interest payments-0.3-0.2-0.3-0.4-0.4-0.4-0.6-0.3
Domestic financing (net)-1.6-4.0-0.20.2-3.8-3.3-1.30.2
External contribution10.613.010.29.515.716.113.63.0
Grants9.78.27.28.111.914.112.22.5
External financing (net)1.04.83.11.53.82.11.40.4
Use of fiscal space18.520.322.122.925.427.626.88.3
Wages5.25.24.94.94.64.34.5-0.7
Other current spending7.48.512.212.412.313.213.76.3
Development expenditures6.06.64.95.68.510.18.62.7
Memorandum item:
Pro-poor spending4.05.36.26.97.510.010.76.7
Source: IMF staff calculations.

Figure 2.6a.Rwanda: Aid and Capital Expenditure

Scaled-up aid would initially finance large infrastructure projects and some recurrent spending …

Source: IMF staff calculations.

Figure 2.6b.Rwanda: Government Revenue and Expenditure

… but an increase in revenue will eventually replace aid.

Source: IMF staff calculations.

The main challenge is to formulate an expenditure program that is consistent with Rwanda’s growth and MDG objectives while keeping the economy stable. Depending on the government’s spending and absorption decisions, pressure on the real exchange rate may emerge. An effective response will require close coordination of fiscal, monetary, and exchange rate policies. To deal with these pressures, Rwanda would need to do the following:

  • Gradually increase demand for domestic goods and services to minimize inflationary pressures, and raise the absorption of spending by increasing the import content of expenditures. This could be achieved by front-loading public capital (import-intensive) spending to address the infrastructure gap and induce a supply response in the economy. Over the long term, public investment would gradually decline to make room for higher recurrent social spending.

  • Sterilize domestic spending using foreign exchange sales to raise absorption rather than issuing domestic debt, which could crowd out private investment.

  • Enhance the productivity of the export sector to offset the impact of an exchange rate appreciation on competitiveness.

  • Strengthen institutions and management capacity to improve the sequencing of reforms and the coordination of sectoral policies to improve efficiency, e.g., by enhancing coordination with donors in terms of increased predictability, harmonization, and alignment of aid; and strengthening coordination with other stakeholders in reviewing and adjusting development objectives.

Tanzania: Mobilizing Revenue and Donor Assistance19

Fiscal space in Tanzania has increased from both domestic revenue mobilization and more external aid. The donor assistance is a response to Tanzania’s wide-ranging reform program and its prudent macroeconomic policies. At the core of these reforms were modernization of the tax system, in line with Tanzania’s shift to a market-oriented economy, and strengthening of revenue administration and PFM institutions. Both were completed with substantial technical assistance from the IMF. Since 1999/2000 (fiscal year July–June), Tanzania’s successful policies enabled the authorities to increase spending from 17.9 percent of GDP to more than 25 percent in 2005/06 while GDP was growing on average by 6 percent a year (Table 2.6).

Table 2.6.Tanzania: Sources and Uses of Fiscal Space(Percent of GDP)
Change
1999/002000/012001/022002/032003/042004/052005/062000-06
Source of fiscal space17.215.615.818.921.224.025.07.8
Domestic contribution11.911.410.811.211.813.815.63.7
Revenues11.312.011.812.112.713.314.02.8
Domestic interest payments-1.2-1.0-0.7-0.6-0.6-0.7-0.90.2
Domestic financing (net)1.80.4-0.3-0.4-0.31.12.50.7
External contribution5.44.25.17.79.510.29.44.0
Grants4.53.74.46.26.07.76.01.5
External financing (net)0.90.50.71.63.42.63.42.5
Use of fiscal space17.215.615.818.921.224.025.07.8
Wages4.24.03.94.04.04.14.30.2
Other current spending6.37.88.710.011.612.714.48.1
Development expenditures6.73.83.35.05.67.16.3-0.4
Memorandum item:
Pro-poor spending6.06.48.69.59.612.612.86.8
Source: IMF staff calculations.

More domestic revenue has been mobilized because revenue administration was reformed and a modern tax system adopted. The Tanzania Revenue Authority was created in 1996; subsequent reforms have been guided by two successive five-year business plans. Major tax administration achievements have been the creation and consolidation of the large-taxpayers department and organization of the domestic revenue department, created by merging the VAT and income tax departments. The merger was accompanied by organizational improvements, strengthened audit capacity, and enhanced and integrated information systems. In customs, operational processes and policies are being modernized. The result is more revenue collected and impediments to trade removed. Tanzania’s new tax system is based on a limited number of taxes, each with a relatively broad base. A new Income Tax Act was passed in 2004; the act streamlined allowances, introduced self-assessments, and rationalized small taxpayer administration. In 2005 the VAT registration threshold was doubled and its administration simplified. These reform efforts have paid off; revenues have surged, especially in the past three years. They exceeded 16 percent of GDP in 2006/07.

Tanzania’s PFM has also improved. Reforms have put resources to more efficient use, freeing up public funds and also signaling the country’s commitment to reform, which invigorated donor support. The government in 1998 launched the Public Financial Management Reform Program to make financial management more effective with better use of public resources and clearer accountability. Since then, significant progress has been made in budget formulation, execution, and monitoring: a medium-term expenditure framework has been adopted, an integrated financial management system has been deployed across the public sector, and a single treasury account has been introduced. Using the government’s Strategic Budget Allocation System in formulating budgets has helped align spending appropriations with Tanzania’s poverty reduction priorities. A review by IMF and World Bank staff in 2004 found that Tanzania had the highest ranking on the quality of public expenditure management systems of 26 HIPC countries, though there is still scope for improvement.

In support of these reforms, donors have substantially increased their assistance to Tanzania. Concessional external financing and grants combined have increased since 1999/2000 from 6 percent of GDP to a projected 11.3 percent in 2007/08. Foreign-financed spending is now more effective because aid has increasingly been channeled through the PFM system, either as untied budget support or in funds for sector-specific activities. Moreover, Tanzania has adopted initiatives to better coordinate donor support.

Donors also helped create fiscal space through substantial debt relief. At the HIPC completion point, reached in 2001, Tanzania’s debt in net present value terms fell by 54 percent (not counting additional bilateral relief), restoring the country to debt sustainability. On flow terms, the debt service savings represented on average about 1 percent of GDP a year for 1999/2000–2005/06. More recently, MDRI relief has equaled over 1 percent of GDP a year for 2006/07–2007/08.

The expanded resources have produced a steady rise in government spending. This is at the core of Tanzania’s poverty reduction strategy, articulated most recently in the MKUKUTA (Tanzania’s PRSP): public spending on MKUKUTA priorities reached an estimated 12¾ percent of GDP in 2005/06, up from about 6 percent in 1999/2000.20

Because of the brisk growth in domestic revenue and donor support, the government had almost no recourse to domestic financing of the budget and there was no crowding out of private sector activity.21 As a result, credit to the private sector grew amply; thus, the rise in antipoverty spending did not jeopardize Tanzania’s gains from reducing inflation to the low single digits (down from about 30 percent before the reform program took hold).

Uganda: Creating Fiscal Space through Strengthened Revenue Administration22

In Uganda, continued good economic performance hinges on improving the country’s infrastructure, access to education, and health care. Uganda’s landlocked status, inadequate road and railway infrastructure, and insufficient supply of electricity drive up production costs and undermine competitiveness. The country also faces a shortage of technical skills to support a growing economy.

Figure 2.7.Uganda: Net Donor Inflows

Source: IMF staff estimates and projections.

Figure 2.8.Uganda: Government Expenditure and Revenue

Source: IMF staff estimates and projections.

In recent years, substantial donor assistance has expanded the fiscal space. Donors have financed almost half of Uganda’s spending, providing the resources needed for development (Table 2.7). HIPC and, later, MDRI relief helped keep Uganda’s debt sustainable (the debt-to-GDP ratio is now 14 percent).

Table 2.7.Uganda: Sources and Uses of Fiscal Space(Percent of GDP)
Change
2000/012001/022002/032003/042004/052005/062001-06
Source of fiscal space21.721.921.520.419.618.7-3.0
Domestic contribution10.610.811.09.711.310.90.2
Revenues11.312.212.212.712.813.21.8
Domestic interest payments-0.6-0.9-1.0-1.5-1.1-1.1-0.5
Domestic financing (net)-0.1-0.5-0.2-1.5-0.5-1.2-1.1
External contribution11.011.110.410.78.37.8-3.3
Grants7.97.06.59.07.96.6-1.3
External financing (net)3.24.13.91.70.41.2-2.0
Use of fiscal space21.721.921.520.419.618.7-3.0
Wages4.45.45.25.25.15.00.7
Other current spending5.87.16.77.06.46.50.7
Development expenditures9.49.69.48.37.87.2-2.2
Other12.1-0.10.20.00.2-0.1-2.2
Memorandum item:
Pro-poor spending4.25.85.55.55.15.01.6
Source: IMF, staff calculations.

That source of fiscal space is drying up, even as the need for fiscal space to finance development remains acute. New donor commitments have not kept pace with Uganda’s needs. Moreover, the government wants to further reduce Uganda’s dependence on donor assistance to alleviate the pressure on the exchange rate stemming from sales of foreign exchange for sterilization and to encourage private sector–led growth. At the same time, public investment in infrastructure, education, and health remains essential, since private investment is still minimal.

The main plan for creating fiscal space is to increase the revenue-to-GDP ratio through better tax administration. At 13 percent of GDP, Uganda’s revenue is low compared with both other countries in the region and the sub-Saharan African average. Given the narrow tax base, however, raising tax rates further is not a viable option. Accordingly, the Uganda Revenue Authority (URA) plans to use administrative improvements and productivity gains to increase tax collection to about 16 percent of GDP over the next five years (see Box 2.2). Reprioritizing spending and making it more efficient will further expand the fiscal space.

  • Reprioritization. The medium-term budget framework identifies rural development (enhanced extension, financial, and marketing services for farmers); education (information technology); and infrastructure (road and electricity projects) as priorities.

  • Efficiency. Uganda’s PFM system has met 9 of the 16 benchmarks in the Bank-Fund review of HIPC countries conducted in 2004, but it is plagued by underbudgeting and excessive reliance on supplementary budgets. This has led to unintended shifts in expenditure composition and to accumulation of arrears. The government aims to strengthen its monitoring and evaluation functions and improve service delivery. The latter is particularly important because limited capacity to undertake public investment projects—rather than availability of financing—is often the binding constraint.

Box 2.2.Reforms at the Uganda Revenue Authority

The Uganda Revenue Authority (URA) was established in 1992 as a semiautonomous agency. By 2004 it had succeeded in raising the revenue-to-GDP ratio from 7 to 12 percent, but progress had been slowed by insufficient attention to large taxpayers, inadequate computerization, and perceived corruption.

Starting in 2004, reforms at the URA have been reinforcing governance and management and overhauling its negative public image, launching the large taxpayer office, and computerizing. The reforms paid off; the revenue-to-GDP ratio rose to 13 percent despite an acute electricity crisis. Raising the revenue-to-GDP ratio further, to the current target of 16 percent, will require (1) adopting modern revenue administration methods, especially as related to taxpayer registration; centralizing data on taxpayers and transactions; more frequent compliance audits, and sharing information with other countries in the region about incoming trade; and (2) firming up the tax regime for small and medium-sized taxpayers.

Uganda’s new Debt Management Strategy (DMS) addresses the intertemporal aspect of fiscal space. The strategy outlines the principles for external and domestic borrowing, including borrowing only on concessional terms and only for budget support and essential infrastructure (electricity, transportation, and water) projects; it also sets strict limits on loan guarantees. The DMS is also designed to improve expenditure management and avoid arrears, which can shrink fiscal space.

Several factors complicate the task of creating and maintaining fiscal space in Uganda. Capacity to collect taxes is constrained by the structure of the economy, which is highly informal and in which the share of agriculture in GDP is 40 percent. In the next few years, the government will also have to spend about ½ percent of GDP annually to subsidize electricity generation. Recently announced investment incentives (tax breaks for exporters) are not projected to be overly expensive (about 0.1 percent of GDP annually) but could give rise to loopholes that undermine tax collection efforts. Further expansion of the fiscal space in Uganda will be possible once the electricity crisis is resolved and the shares of service and manufacturing sectors in GDP rise.

Note: This chapter was prepared by Jan Gottschalk and Calvin McDonald.

Fiscal sustainability refers to the continuous capacity of the government to finance its desired expenditure programs, service its debt obligations, and ensure its solvency.

According to Heller (2005), raising the tax share to at least 15 percent should be a minimum objective for many countries. Such a target may be ambitious, though, for countries emerging from conflict or those with a large subsistence sector.

For a detailed discussion, see Berg and others (2007).

This section was prepared by Catherine Pattillo.

This section was prepared by Stanislaw Maliszewski.

The fiscal year runs from July to June.

This section was prepared by Stella Kaendera and Wayne Mitchell.

This section was prepared by Robert Sharer and Alejandro Hajdenberg.

The methodology to account for priority spending was modified in the 2005/06 when MKUKUTA was put in place.

Except for 2005/06, when a severe drought created a number of emergency outages.

This section was prepared by Dmitry Gershenson.

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