Chapter

Annex 4. Minimizing the Impact of Fiscal Consolidation on Growth, and Enhancing Equity

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
November 2013
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Large and rising fiscal vulnerabilities necessitate fiscal consolidation across the region. Given the weakness of the recovery and complex socioeconomic dynamics, it will be important to design fiscal consolidation packages in a way that helps contain its negative impact on near-term growth while enhancing equity and medium-term growth prospects. Instruments for achieving these goals could include revenue mobilization centered around broadening tax bases and progressivity, combined with a reorientation of spending toward low-income households and growth-enhancing capital expenditures, while moving away from generalized subsidies and hefty public wage bills. The pace and prioritization of these reforms will depend on country-specific circumstances, including the availability of financing. Supportive monetary and exchange rate policies, structural reforms, and a broad communication strategy will also be important for policy success.

The Great Recession of 2008–09, compounded, in some cases, by the aftermath of the Arab Spring, led to large fiscal deficits and public debt in many Middle Eastern and Central Asian economies (Figure A4.1). Debt exceeds 80 percent of GDP in Egypt, Jordan, Lebanon, Mauritania, and Sudan. In Bahrain, the Kyrgyz Republic, Morocco, Pakistan, Tunisia, and Yemen, high deficits, or projected oil price declines for oil exporters, raise fiscal vulnerabilities despite their moderate debt ratios. In these countries, substantial and prolonged fiscal consolidation will be necessary to maintain fiscal sustainability and rebuild buffers, especially in an environment of weak growth prospects and high global and regional uncertainties. In most oil exporters, fiscal vulnerabilities from high breakeven oil prices, and insufficient savings to support spending for future generations, also call for fiscal consolidation. Across the region, the extent and pace of consolidation will depend on country specifics such as financing needs, external balances, the sociopolitical environment, and growth developments.

Figure A4.1Fiscal Deficits and Debt

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.

Successful fiscal consolidation depends on a policy mix that keeps the impact on growth to a minimum while enhancing equity. Containing the negative impact on incomes and jobs while preventing a worsening of the income distribution is critical to gaining and keeping the public support needed to sustain the consolidation. For countries with very low fiscal and external buffers, a delay in fiscal consolidation could severely worsen growth and inequality, should a drying-up of market financing force a sudden, even greater fiscal adjustment accompanied by a deep recession.

Revenue mobilization and spending reorientation will be essential if the policy mix is to achieve the dual objectives of growth and equity. The region’s low tax revenues (relative to GDP; Figure A4.2), combined with small revenue multipliers,1 make a case for increased revenue mobilization. The right combination of revenue measures would also improve the redistributive impact of fiscal policy, which has so far been limited by weak taxation. Smaller multipliers on current than on capital spending suggest that risks to near-term economic activity could be limited by cutting current spending and channeling part of the resulting savings into growth-enhancing capital spending. This capital spending could also enhance long-term growth prospects—a critical factor in lowering debt ratios—by boosting productivity and growth potential. However, the pace of cuts to current spending (if financing and external positions allow) needs to be aligned with the development of targeted social safety nets or broader cash compensation schemes. The pacing should also be designed to contain the negative effects on growth, which are amplified when output is below potential (the current cyclical position of many economies in the region) (Baum, Poplawski-Ribeiro, and Weber, 2012).2 Equity implications will depend on the detailed composition of revenues and current expenditures. The success of this fiscal policy mix will also depend on supportive monetary policies, structural reforms to increase growth, and a broad communication strategy to build political consensus.

Figure A4.2Total Tax Revenue and Expenditure, 2012

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.

Note: Blue bars represent CCA countries, and orange bars represent MENAP oil importers. EMDC = emerging market and developing countries.

Mobilizing Tax Revenues

Low tax revenues and weak progressivity pose a challenge (Figure A4.3). Revenues in most MCD economies are lower than in other emerging and developing economies. This gap largely reflects low income tax and corporate tax rates and weak collection, which stems from high tax exemptions and compliance issues.3 Tax progressivity is also low across the region largely because the main source of revenues for oil importers is taxes on goods and services, and for oil exporters it is oil revenues along with some income and trade taxes. In the medium term, these revenue challenges are expected to persist in oil importers. In oil exporters, projected declines in oil prices underline the importance of developing non-oil sectors and raising taxation in those sectors from their currently very low levels.

Figure A4.3MCD: Tax Rates and Revenue, 20121

Sources: National authorities; KPMG; Deloitte; and IMF staff calculations.

Note: Blue bars represent CCA countries, and orange bars represent MENAP oil importers (except last chart). EMDC = emerging market and developing countries.

1 Or latest available data.

2 Calculated as VAT revenue, divided by the product of VAT rates and private consumption.

Revenue measures should focus on strengthening tax structures while keeping the impact on growth to a minimum and improving equity. Measures that can be taken as first steps include the following:

  • Broaden the tax base. Conventional wisdom stresses base broadening in preference to an across-the-board rate increase because the latter can be regressive4 and its implementation politically challenging. New evidence confirms that base broadening is also better for growth—especially for value-added taxes (VAT) (Acosta-Ormachea, Keen, and Yoo, 2013)—and for improving the business environment. Consequently, tax exemptions and deductions (except those targeted to the poor) should be heavily reduced for all taxes and, whenever possible, multiple VAT rates consolidated into a single rate. A solid communication strategy—for example, the publication of an annual tax expenditure review highlighting costs and benefits—would be critical to facilitating public buy-in for these efforts.

  • Increase the progressivity of income taxes. More progressive income taxes would improve equity while having little effect on growth, and could include raising the current relatively low marginal rates on the highest income earners, and, where appropriate, on capital income.5 To start, cuts in top rates for personal and corporate income tax rates during the past five years could be undone (for example, in Jordan, the Kyrgyz Republic, and Uzbekistan).

  • Raise excise and property taxes. Raising the currently low levels of excise taxes (Figure A4.4),6 especially on luxury goods, and property taxes (while protecting low-income property owners), would achieve gains in revenue, efficiency, and fairness, with benign effects on growth given that they mostly affect the wealthy. However, implementation of property taxes would require substantial upfront investment in administrative infrastructure, which would include establishing a comprehensive cadastre and valuation mechanisms, and carrying out effective enforcement.

Figure A4.4Property and Excise Tax Revenue, Latest Available

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.

Note: Blue bars represent CCA countries, and orange bars represent MENAP oil importers. EMDC = emerging market and developing countries.

Gradual tax and customs administration reforms would further stimulate revenue mobilization and support prospective growth. A focus on strengthened administrative capacity, enhanced compliance, and efficiency will raise tax revenues and level the playing field for companies while promoting foreign investment and competitiveness. Stable and simplified tax codes and tax regimes for small and medium-sized enterprises would advance efficiency. In countries in which VAT revenue is large, a risk-based compliance system (including an automated VAT refunds system) would increase tax yield, facilitate business operations, and reduce unequal tax treatment across companies. International experience also suggests that a large taxpayers’ department, operating through a small number of offices, can lower tax evasion and improve administrative efficiency. Yields on import VAT, excise, and international trade taxes would rise substantially with customs administration reforms.

Reorienting Spending

Consolidation is complicated by large and poorly targeted current spending (Figure A4.5). Since the onset of the Great Recession, spending has often outpaced output growth. Across the region, to mitigate the adverse social effects of lower growth and higher unemployment, many governments increased outlays on energy subsidies and wage bills (through hiring and wage increases). This new spending was partially offset by reducing already low capital spending and, sometimes, maintenance, education, and health spending. In the aftermath of the Arab Spring, these spending efforts were intensified in the ACTs and their neighbors (including the GCC and Lebanon). Inequities rose because broad-based subsidies primarily benefit the wealthiest. Hikes in public wage bills also tend to raise inequality,7 reflecting government employees’ above-average position in the income distribution. In a few countries, the spending power of poorer households was eroded by high inflation caused by monetization of large public deficits and high food and energy prices.

Figure A4.5MCD: Expenditure Components and Inequality

(Percent of GDP)

Sources: National authorities; World Bank World Development Indicators; and IMF staff calculations.

1 Blue bars represent CCA countries, and orange bars represent MENAP oil importers.

2 Subsidy and transfer expenditure data not available for Qatar, Turkmenistan, or Uzbekistan.

3 Benefit incidence is the share of social spending allocated to the poorest 40 percent of the population.

4 Orange bars represent MCD countries; gray bars represent others. ARG = Argentina; BGD = Bangladesh; BDR = Bulgaria; BRA = Brazil; LVA = Latvia; MEX = Mexico; RWA = Rwanda; THA = Thailand; TUR = Turkey; UKR = Ukraine.

Carefully chosen fiscal spending tools will contain the negative impact on growth, improve targeting, and reduce expenditure rigidities. To that end, many countries with large, broad-based energy subsidies, including some ACTs, have begun to gradually phase them out, to varying degrees and taking into account sociopolitical conditions (see Box 2.4). Channeling part of the resulting savings toward better-targeted social safety nets or broader cash compensation schemes will mitigate the adverse effects on the poorest of higher energy tariffs and other reforms.

Real growth of public wage bills also needs to be contained—particularly in the ACTs, where their growth exceeds that in the rest of the region (Figure A4.6). Using the public sector as employer of first and last resort is no longer an option in those countries whose fiscal buffers are running low. It should also be discouraged in countries where inflated public sector salaries reduce the appeal of private sector jobs for the best workers. Near-term consolidation efforts can be complemented by medium-term plans for comprehensive civil service reforms that review the size and structure of the civil service while creating a skilled and efficient government workforce.

Figure A4.6Real Wage Growth

(Percent)

Sources: National authorities; and IMF staff calculations.

At the same time, spending on growth-enhancing areas needs to be protected and, where possible, increased. Channeling part of the net savings from the consolidation efforts above into social outlays on health care, education, and training—especially for low- and middle-income households—and into efficient capital spending, should create jobs and reduce inequities8 in the near term, while strengthening long-term growth prospects. To ensure its effectiveness, the quality and efficiency of all growth-enhancing spending will need to be monitored and implementation capacity increased. Raising the efficiency of capital spending at any stage of the public investment management process9 could benefit all countries in the region. Sizable growth dividends can result from even a small increase in capital spending. Public-private partnerships (PPPs) can lessen the burden on capital spending budgets, but only if the political environment supports them and if strong PPP legal frameworks and mechanisms can be established to mitigate the risk of large contingent liabilities. On average, the implementation phase for capital projects is the most challenging for MCD countries, relative to comparator regions (Figure A4.7).

Figure A4.7Public Investment Management Index

(Index components, 0 = lowest, 4 = highest)

Source: Dabla-Norris and others (2011).

Note: EM = emerging market; LAC = Latin America and the Caribbean.

Strengthened reporting, monitoring, and procurement systems are essential for improving the efficiency of capital spending. Appropriate vetting and prioritization systems (i.e., choosing projects that relieve infrastructure bottlenecks, complement private investment, and enhance productivity), timely allocations of recurrent expenditures (in line with the budget), and routine evaluations upon project completion and internal audits would underpin improvements in the appraisal, selection, and project evaluation stages.

Supporting Measures and Policies

Appropriate monetary, exchange rate, and structural policies are necessary to support successful fiscal consolidation. In some cases, low interest rates for an extended period, resulting from accommodative monetary policy, would both reduce the cost of public debt and stimulate private sector activity. Inflationary pressures are likely to be offset by the effects of fiscal consolidation, so adverse inflationary effects on inequality or competitiveness would be avoided. In other cases, where tight monetary policy is needed in the near term to protect the current account and the exchange rate, and to contain inflationary risks, its pace and intensity can be coordinated with fiscal policy. In the medium term, a flexible exchange rate and structural reforms that attract foreign direct investment and promote competitiveness, private sector growth, and international trade would boost potential growth (Box 1.1; Box 2.6 of the November 2012 Regional Economic Outlook: Middle East and Central Asia) and lower the debt burden.

Fiscal multipliers are defined as the ratio of a change in output to an exogenous change in government spending or tax revenues.

The region’s fiscal multipliers are estimated to be less sensitive to output gaps.

The tax effort is under 50 percent for Algeria, Armenia, the GCC (excluding Qatar and the United Arab Emirates), Iran, Kazakhstan, Libya, Pakistan, and Sudan (Fenochietto and Pessino, forthcoming; and the October 2013 Fiscal Monitor). The tax effort and the value-added tax (VAT) collection efficiency (C-efficiency) are well below the average for emerging market and developing economies.

Particularly for income and consumption taxes.

In China, for example, greater progressivity was introduced by reducing the starting rate and widening the band to which the top rate applies (see the October 2013 Fiscal Monitor).

Nominal increases should aim to increase the real value of excises levied as fixed monetary amounts.

See “Kuwait: 2012 Article IV Consultation,” IMF Country Report No. 12/150 (Washington, 2012).

Empirical literature finds that education is one of the main determinants of cross-country variations in inequality (Barro, 2008; De Gregorio and Lee, 2002; World Economic Outlook, October 2007).

Dabla-Norris and others (2011) provide more details on the phases of public investment management.

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