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Chapter 4. Fiscal Frameworks

Author(s):
Charlotte Lundgren, Alun Thomas, and Robert York
Published Date:
August 2013
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Fiscal policy takes center stage in making the most of large endowments of natural resources. The prospects for substantial proceeds from the exploitation of natural resources provide opportunities to promote economic development in sub-Saharan Africa (SSA), notably through much-needed investment in infrastructure and human capital. Managing these resources effectively is therefore critical. This chapter draws heavily upon recent IMF analytical work, particularly “Macroeconomic Policy Frameworks for Resource-Rich Developing Countries” (IMF, 2012b), to present the main arguments and policy options.

The high volatility and uncertainty of natural resource revenue complicates macroeconomic management and medium-term budget planning. Having a fiscal framework that can help anchor appropriate medium-term targets is essential. To the extent that natural resource revenue is exhaustible, the complex issues of long-term sustainability, intergenerational equity, and the need for effective saving vehicles are brought to the fore and must be addressed.

As stressed in IMF (2012b), a number of elements should be included in fiscal frameworks for resource-rich countries, including the following:

  • Indicators to assess the fiscal stance in support of macrofiscal stability;
  • Rules that anchor the short- to medium-term fiscal policy path but offer sufficient flexibility to channel precautionary savings to urgent spending needs, in particular, for scaling up growth-enhancing expenditure;
  • An appropriate benchmark for assessing long-term fiscal sustainability; and
  • A strong institutional setup with adequate capacity to forecast revenue, manage expenditure, and set medium-term targets for fiscal policy.

The relative importance of each of these elements in the design of a fiscal framework depends on country-specific factors (such as the size and extraction profile of the resource reserves) and priorities. As a general rule, however, in resource-rich countries where the capital stock is deficient—which is the case in most SSA countries—the main priority for the fiscal framework should be to balance concerns about macroeconomic stability against economic development. In countries in which resource revenue is perceived to be temporary as opposed to permanent (or long lasting), intergenerational equity issues must also be addressed. There is no “one size fits all,” and factors such as the country’s development level, credit constraints, demographic profile, and absorptive and institutional capacity should be considered in designing the fiscal framework.

Policy Challenge: Alleviating Capital and Credit Constraints While Maintaining Macroeconomic Stability and Fiscal Sustainability

There are good reasons to rethink Friedman’s (1957) previously dominating expenditure-smoothing approach to fiscal management of natural resources. As noted in Chapter 3, this classical view of natural resource management in the academic literature and among policymakers placed primary importance on the permanent income model, which implies maintaining annual current spending equal to the implicit return on the present value of future resource revenue. In this way, the permanent income model provides a benchmark for the nonresource primary deficit that could be sustained indefinitely. In the past, IMF staff often relied on this model to guide policy discussions (IMF, 2012c) but have recently moved away from this approach for a variety of reasons: (1) the permanent income model addresses only the constant flow of consumption and not the appropriate rate of investment; (2) it fails to address the capital and credit constraints in many resource-rich low-income countries like those in SSA; (3) it ignores the reality that current generations may be poorer than future ones, which would make the marginal utility of consumption higher for the current generation; and (4) it fails to take into account that the bulk of resource reserves in SSA are most likely yet to be discovered.

Consequently, more flexible fiscal framework models that can accommodate scaled-up investment can be justified, and this is now reflected in IMF staff advice to many resource-rich countries in this position (IMF, 2012b). This flexibility can be achieved in a number of ways, including by exploring options for short- and medium-term fiscal anchors, long-term fiscal sustainability benchmarks, and sovereign wealth funds (SWFs). The best framework for a country depends on country-specific economic and institutional circumstances, including the level of resource revenue dependency, resource wealth and reserves, revenue horizon, and development needs. Depending on these factors, established principles for fiscal frameworks can be modified to allow for more flexibility to front-load growth-enhancing investments while maintaining macroeconomic stability.

Several options for short- and medium-term fiscal anchors are available, each with its pros and cons:

  • Nonresource balance anchors are defined using the standard fiscal balance excluding net resource revenue. Nonresource balance anchors allow for effectively managing short-term demand fluctuations and insulate fiscal policy from revenue volatility. Specific nonresource targets can be set taking absorptive capacity into account.
  • Price-based rules or structural balance rules seek to smooth the fiscal effect from changes in resource revenue by using a reference price to estimate revenue based on a moving average of past or future resource prices (or both past and future prices). The shortcoming of this anchor is that it ignores the exhaustibility of resource revenue and changes in production volumes, although sustainability concerns can be addressed by deliberately cautious revenue projections.
  • Expenditure growth limits can cap the growth of government spending in nominal or real terms, or as a percentage of resource revenue. The benefits are its simplicity, ease of monitoring, and relationship to absorptive capacity (i.e., growth rates). A disadvantage of expenditure growth limits is that they may reduce the incentives to mobilize nonresource revenue. Expenditure growth limits can be used to complement a price-based or structural balance rule that does not take into account changes in production volume.

With several options for short- and medium-term fiscal anchors at hand, how can country authorities be guided in their choices? A key question to ask is how long the resources are likely to last. As a general rule, countries with long resource horizons should be mainly concerned with managing the volatility of resource prices and ensuring macroeconomic stability. Countries with shorter resource horizons face similar problems but in addition, must address the issue of long-term fiscal sustainability once the resource is exhausted (Box 4.1).

Box 4.1.Capital-Constrained Resource-Rich Sub-Saharan African Countries: Anchors and Benchmarks

In all types of economies, the overall fiscal balance (total revenue minus total spending) is used as an indicator of the net financial position, that is, whether the government is increasing or reducing its financial wealth. The primary fiscal balance (the overall fiscal balance excluding interest payments) gives an indication of the fiscal stance—that is, whether fiscal policy has an expansionary or contractionary effect on domestic demand. The recommendation for resource-rich countries, given that resource revenue typically originates from abroad, is to complement the analysis of the fiscal balance by also considering the nonresource primary fiscal balance (the overall fiscal balance, excluding interest payments and resource revenue and resource expenditure). Beyond these basic indicators, IMF staff have recently recommended a range of anchors and benchmarks (Table 4.1.1) to guide fiscal policies in capital-constrained, resource-rich SSA countries (IMF, 2012b).

Table 4.1.1.Capital-Constrained Resource-Rich Sub-Saharan African Countries: Anchors and Benchmarks
Short- or Medium-Term Fiscal Anchors
Long Resource Revenue HorizonShort Resource Revenue HorizonLong-Term Fiscal Sustainability Benchmarks
Price-based rule (structural primary balance rule with price smoothing)Expenditure growth ruleNonresource primary balance ruleModified permanent income model ruleFiscal sustainability framework (modified debt sustainability framework)
Aims to determine expenditure levels on the basis of smoothed resource revenue for a given fiscal target; a smoothed estimate of resource revenue is used to determine the expenditure envelope. Helps insulate spending from price volatility.Sets a limit on the growth of government spending. Useful for limiting the procyclicality of fiscal policy and in cases of absorptive capacity constraints (e.g., overheating, large current account deficits). Usually used in combination with a price-based rule.The target should be set in line with long-term sustainability benchmarks and calibrated in the short-term sustainability depending on cyclical conditions.Deviates from the traditional permanent income model by allowing a scaling up of investment in the medium term, but followed by a scaling down of spending after the scaling up period to rebuild and preserve net financial wealth. It does not consider the growth impact or replacement and recurrent costs associated with additional investments.Based on a debt sustainability framework. Aims to stabilize net resource wealth (over the longer term) at a level lower than what the permanent income model or the modified permanent income model would imply, while allowing scaling up of expenditures. Can consider growth impact and replacement and recurrent costs associated with additional investment.
  • If a country with a relatively short resource revenue horizon focuses only on the overall fiscal balance or the overall primary fiscal balance (the overall fiscal balance excluding interest payments) to guide fiscal policies, it runs the risk of an abrupt expenditure adjustment when revenues from natural resources come to an end. If the nonresource primary deficit is relatively large, the sustainability of the fiscal position could be jeopardized even before the natural resource is exhausted. Therefore, the conventional fiscal indicators should be complemented with indicators that explicitly exclude the resource, such as the nonresource primary balance. The nonresource primary balance—the overall primary balance excluding (net) interest payments and (net) resource revenue, preferably scaled to nonresource GDP1—provides a measure of the underlying fiscal policy stance and the impact of government operations on domestic demand, and helps to delink fiscal policy from the volatility of resource revenue. This is a better anchor for fiscal policy for countries with a short revenue horizon over the short to medium term, compared with, for example, the primary balance alone.
  • A country with a long resource horizon, however, need not worry about exhaustibility of the resource and could focus on managing volatility and avoiding procyclical fiscal policies. In this case, a price-based rule (based on price smoothing) or a structural primary balance indicator is a useful fiscal anchor. If public expenditures move in tandem with natural resource revenues, expenditures will increase (decrease) as natural resource prices increase (decrease), thus reinforcing the effect on domestic demand from changes in resource prices and resulting in procyclical fiscal policies. More to the point, misjudgment of the sustainability of temporary increases in resource prices and inadequate fiscal buffers to sustain spending levels when prices decline are common reasons behind boom-bust cycles in resource-rich economies (Chapter 2). Using a price-based rule or a structural fiscal indicator can help break this link. A structural-type fiscal indicator uses a reference price for the natural resource determined by a price formula or independent committee of experts, as in Chile (Box 4.2). This structural indicator ensures that resource revenue is more or less independent of the business or commodity-price cycle. Price formulas can take a number of forms giving various weights to historical and forward-looking resource prices. The resulting structural resource revenue can then be used either in the budget process to project revenue or to derive a “structural” primary balance2 as the basis for a fiscal rule.
  • The structural balance rule can be usefully combined with an expenditure growth rule or ceiling. Such a rule, defined as the growth of expenditure or expenditure as a share of nonresource GDP, can further help avoid volatility and procyclicality. It can also be a helpful tool in guiding the pace of investment growth when a country faces capacity constraints (Berg and others, 2011).

The fiscal framework and its anchors should be guided by an assessment of long-term fiscal sustainability, which could be defined as the ability of the government to sustain spending, tax levels, and other policies in the long run without running into insolvency problems. This is relevant for all resource-rich SSA countries and especially those with a short resource revenue horizon.

The permanent income hypothesis provides a useful framework for assessing long-term sustainability, although the model should be appropriately modified to accommodate some scaling up of public spending. This modification can be made by allowing short-term deviations from the permanent income model’s constant expenditure path; countries could front-load spending to scale up growth-enhancing public investment and reduce spending later on, to keep spending broadly constant over the longer term. Although this modification leads to some improvement in the analytical framework, it still falls short of the ideal because even a modified version of the classical model fails to take account of potential growth-enhancing effects from scaled-up public investment. These growth-enhancing effects are potentially significant and could yield high fiscal returns over time, which would lessen the need for compensatory spending reductions in the future.

Alternative approaches to assessing long-term sustainability that explicitly take into account expected growth-enhancing effects from higher investment should, therefore, be considered. This could be done either by using a fiscal sustainability framework combined with a debt sustainability framework that is modified to take account of the growth impact from investment, or by means of alternative models (Box 4.3). The alternative models are driven by a number of simplifying assumptions, including that windfall resource revenue is primarily used for public investment or other growth-enhancing spending. The results are also sensitive to the assumptions made about efficiency of these resources and the quality of those investments (Chapter 5).

Box 4.2.Chile’s Experience with Fiscal Rules

Chile produces about one-third of the world’s copper; the commodity accounted for 54 percent of Chile’s exports and nearly 14 percent of its fiscal revenue in 2012. With an expected duration of at least 50 years, copper reserves can be considered long lasting. Chile also has a strong record of macroeconomic stability and sustained growth, with annual real GDP growth averaging 5.3 percent during 1991–2011. This growth performance has been backed by a strong macroeconomic policy framework that includes inflation targeting, a flexible exchange rate, and a fiscal rule.

The fiscal rule, adopted in 2001, has two objectives: (1) to contribute to fiscal and macroeconomic stability by insulating public spending from volatility in copper prices and economic activity, and (2) to improve the net asset position of the central government. To meet these goals, an annual structural balance target is set, initially at a surplus of 1 percent of GDP. In the design of the Chilean rule, intergenerational considerations do not play a prominent role. In 2006, the fiscal rule was anchored in the fiscal responsibility law that set guidelines for computing the structural balance and mandated that the administration must set such a target within 90 days of taking office. The exact formula used for determining the structural balance is complex, but essentially captures the difference between trend revenue consistent with trend estimates of output and copper price, and public expenditure. The difference between the overall fiscal balance and the structural balance is the cyclical component of both mining and nonmining revenue.1

The fiscal responsibility law also established rules for managing fiscal resources and set up two sovereign wealth funds, the Pension Reserve Fund (PRF) and the Economic and Social Stabilization Fund (ESSF). The PRF receives revenue of between 0.2 and 0.5 percent of GDP to be used to cover pension guarantees. The ESSF is intended to be a fiscal buffer, receiving any budget surplus left after payment to the PRF and debt amortization, and is to be used to finance deficits at times of revenue shocks. The capital of both SWFs is invested abroad.

Since its introduction, the target for the structural balance has been adjusted several times to respond to changing economic circumstances, but it has remained a strong anchor for fiscal policies. It is worth noting that the fiscal target, even before the legal framework was adopted, was well backed by strong political commitment. In addition, several features of the framework shield it from political interference and ensure transparency: the estimates of potential GDP and long-run copper prices are determined by a group of independent experts; and annual budget reports, including the targets for the next four years and a detailed review of implementation of the previous year’s budget relative to targets, are published.

1 Chile has thus extended the notion of a structural balance further, by also adjusting nonresource revenue to the economic cycle. In many SSA countries, where the economic growth cycle is not well defined and where data shortages and capacity constraints make the estimation of potential output difficult, Chile’s type of structural balance rule may be difficult to apply but might be considered in the future as data and information improve.

Box 4.3.Exploring Alternative Models of Sustainability: The Democratic Republic of the Congo

The Democratic Republic of the Congo (DRC) is a resource-rich country in which decisions on public savings, investment, and consumption are particularly complex because of its political and institutional features. The volatility of commodity prices further complicates macroeconomic management. Copper and cobalt dominate exports (80 percent in 2011), with gold, diamonds, zinc, and coltan adding a further 10 percentage points.

IMF (2012d) assessed the DRC’s fiscal sustainability taking into account the potential growth effects of scaled-up public investment. Simulations were undertaken using a model developed by IMF staff comparing two policy options for the use of windfall revenue: (1) building up a fiscal buffer through external savings (“bird-in-hand”); or (2) increasing public investment. In the first option, the windfall revenue is saved in a sovereign wealth fund that expands significantly over time. The second option, simulating a more balanced approach with an up-front but gradual increase in public investment, produces better macroeconomic results in terms of GDP growth, capital stock, and nonresource GDP than the first option. However, because of absorptive constraints, the direct cost of using more of the windfall revenue for public investment (the sum of the annual difference between gross and effective public investment) is twice as high as in the first option. Moreover, in the second option less of a fiscal buffer is available to offset a potential decline in commodity prices.

Although the findings of these simulations depend on a number of assumptions, they illustrate the possible trade-offs and policy implications of using the windfall resources: (1) in a country with large infrastructure gaps, allocating a higher portion of revenue to public investment may pay off with higher GDP growth and poverty reduction (and these effects may even be underestimated given the catalytic effect public investment could have on private investment); (2) the costs owing to absorptive and efficiency constraints point to the need to reinforce public financial management and build the capacity of the civil service and institutional structures to strengthen government accountability and transparency; and (3) setting up a rule for how much of the windfall resources should be saved in the early years of its exploitation makes it easier for policymakers to resist political pressure to increase government consumption and to boost capital spending above absorptive capacity.

Box 4.4.Ghana’s New Fiscal Rules

Following Ghana’s first major oil discovery in 2007, the government initiated a national consultation on how to manage this newfound wealth efficiently. Although Ghana’s oil reserves are relatively small on a global scale—with production from the current Jubilee field expected to peak at 120,000 barrels a day—there is considerable upside potential from new discoveries. Ghana’s Petroleum Revenue Management Act seeks to strike a balance between macroeconomic stability and the avoidance of procyclical spending, large infrastructure spending needs, and the need to save for future generations.

The act—passed in 2010 ahead of the first full year of production—includes several provisions: a stabilization fund, an endowment fund for future generations, and annual budget funding and earmarking of funding for public investment. Although the framework does not set any specific budget rule with fiscal indicators that take into account resource revenue, the act sets targets for the partition of resource revenue between the budget and the two wealth funds: (1) of the benchmark oil revenue, up to 70 percent is allocated to the budget and at least 30 percent is transferred to the stabilization and the endowment funds; (2) of the allocation to the budget, 70 percent should be devoted to capital expenditure; and (3) of the 30 percent transferred to the funds, 70 percent goes to the stabilization fund and 30 percent to the endowment fund.

The act also provides for regular public reporting by various government agencies, including the Ministry of Finance and Economic Planning, the Ghana Revenue Authority, and the Bank of Ghana. In addition, transparency clauses are consistent with the requirements of the Extractive Industries Transparency Initiative. A strong framework for public accountability is ensured through disclosures of public expenditure and regular scrutiny by the Public Interest and Accountability Committee. The committee must publish semiannual reports that are also submitted to the president and to parliament. The auditor-general provides external audits of the petroleum funds each year, and the Bank of Ghana conducts internal audits, with the governor submitting quarterly reports. In addition, civil society organizations have been very active in monitoring oil revenue management.

Ghana’s setup for managing its oil revenue has positive features with regard to transparency and clear targets for the distribution of the revenue between the budget and the funds. However, as a general principle, SWFs should be a complement to, rather than a substitute for, clear fiscal rules. Although the absence of a budget rule with special provisions for the resource revenue may be motivated by the relative small share of resource revenue out of total revenue in Ghana, the country’s performance in managing its resource revenue will depend on clear fiscal targets and adherence to those targets.

Sovereign wealth funds are useful tools in macrofiscal management and for handling intergenerational issues, but they should not be a substitute for clear fiscal rules. A number of countries have set up SWFs, some with the hope that such a fund would remove the pressure to spend windfall revenue. However, empirical evidence suggests there is no significant difference in the fiscal stance in countries with funds with rigid in- and outflow rules compared with others. One explanation may be the lack of borrowing constraints, which allows governments to borrow to finance the payments to the funds.

An SWF should therefore be seen as a useful complementary tool that is integrated with the budget. Rather than being “development funds” with their own authority to spend, they should be fully integrated with the budget and support the implementation of sound fiscal policies (e.g., financing countercyclical policies). Importantly, they should also enhance transparency and credibility by making revenue and the use of it more visible. Finally, they should maximize the yield on the government’s financial savings. (See examples of SWFs in Box 3.4 and Box 4.4.)

Recommended Reading

    ArezkiRabahThorvaldurGylfason and AmadouSyeds. 2011Beyond the Curse: Policies to Harness the Power of Natural Resources (Washington: International Monetary Fund). ISBN: 9781616351458. www.imf.org/external/pubs/cat/longres.aspx?sk=24843.0.

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    BaunsgaardThomasMauricioVillafuerteMarcoPoplawski-Ribeiro and ChristineJ. Richmond2012Fiscal Frameworks for Resource Rich Developing Countries,IMF Staff Discussion Note 12/04 (Washington: International Monetary Fund). www.imf.org/external/pubs/cat/longres.aspx?sk=25902.0.

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    BergAndrewRafaelPortilloShu-ChunS. Yang and Luis-FelipeZanna2011Public Investment in Resource Abundant Low-Income Countries,IMF Working Paper 12/274 (Washington: International Monetary Fund). www.imf.org/external/pubs/cat/longres.aspx?sk=40105.0.

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    DavisJeffrey M.RolandoOssowski and AnnalisaFedelino2003Fiscal Policy Formulation and Implementation in Oil-Producing Countries (Washington: International Monetary Fund). ISBN: 9781589061750. www.imf.org/external/pubs/cat/longres.aspx?sk=16018.0.

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    IMF2012bMacroeconomic Policy Frameworks for Resource-Rich Developing Countries,IMF Policy Paper August 24 (Washington: International Monetary Fund). www.imf.org/external/pp/longres.aspx?id=4698.

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    IMF2012cMacroeconomic Policy Frameworks for Resource-Rich Developing Countries: Background Paper 1,IMF Policy Paper (Washington: International Monetary Fund; August24). www.imf.org/external/pp/longres.aspx?id=4699.

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    IMF2012dMacroeconomic Policy Frameworks for Resource-Rich Developing Countries: Analytic Frameworks and Applications,IMF Policy PaperAugust24 (Washington: International Monetary Fund). www.imf.org/external/pp/longres.aspx?id=4700.

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1

Given the large volatility of resource GDP and, therefore, total GDP, such an indicator should ideally be expressed through nonresource GDP.

2

This differs from cyclically adjusted balances that take into account output gap fluctuations resulting from nonresource economic cycles. Potential GDP, which forms the basis for estimating output gaps, is generally difficult to calculate in SSA countries because of data constraints, structural changes, and significant GDP volatility.

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