Chapter

CHAPTER 3 Fiscal Adjustment Plans and Medium-Term Fiscal Outlook

Author(s):
Philip Gerson, and Manmohan Kumar
Published Date:
November 2010
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At a Glance

This chapter discusses the status of medium-term plans in the G-20 economies, plus six others with large adjustment needs.16 It finds that most countries have announced medium-term fiscal targets, up to 2013. Although there are some divergences reflecting the response to market pressures, in general the announced size and speed of adjustment strike the right balance between fiscal consolidation and cyclical needs. Specific measures in adjustment plans have been identified in most instances only for 2011, leaving uncertainty on how the targets will be reached. More broadly, plans focus on expenditure cuts, which is appropriate given the high revenue ratios of most of the countries in need of fiscal adjustment. Many countries have yet to specify their longer-term fiscal policy objective, notably the level to which they intend to reverse their public debt ratio. While pension reforms have been enacted or are under way in many advanced economies, generally little has yet been specified on how to tackle long-term health care spending pressures. Many countries are considering supporting adjustment with stronger budgetary institutions, but more is needed in several countries. Among low-income countries, the medium-term fiscal outlook appears favorable, although there is some variation by region and by country group.

Adjustment Plans: Time Frame and Commitment

Fiscal plans typically cover the period until 2013, but few countries have identified a long-term debt objective. Most economies have set out targets until 2013 for the overall balance, although a few go beyond, until 2015 (for instance, the United Kingdom and the United States). In most cases, plans envisage sizable deficit reductions.17 However, few countries have explicitly stated the levels to which they would reduce their sharply increased debt ratios, or have indicated a clear time frame to achieve targets predating the crisis (as in the case of EU countries). This shortcoming is worrisome given the projected future spending pressures and limited fiscal room for maneuver.

There is some diversity in the type of commitment underpinning the adjustment plans, in part reflecting legal and procedural aspects. Half the countries have announced their medium-term goals in the annual budgets, and another six have used medium-term fiscal strategies (or other forms of government strategy documents). In most cases, these fiscal targets are set on a rolling basis and can be revised and adjusted from one year to the next.18 Other countries have relied on more binding multiyear budget frameworks that commit them to a specific expenditure path over the medium term. In this respect, there is an inevitable tension between maintaining flexibility to respond to shocks and providing adequate reassurances that fiscal adjustment will proceed. One way to at least reduce this tension is to strengthen fiscal institutions, including those aimed at improving transparency and accountability (see section on Reform of Fiscal Institutions). This would enable necessary revisions with respect to initial plans to occur as a result of objective circumstances, rather than by what could be perceived as a lack of commitment to underlying fiscal adjustments.

International commitments complement the national fiscal plans with a view to providing some international coordination and peer pressure. At the international level, under the Toronto Declaration of June 27, 2010, the advanced G-20 economies announced they would halve their headline deficits by 2013 (Table 3.1) and stabilize or reduce their debt ratios by 2016. The EU member states have laid out adjustment plans in their Stability and Convergence Programs, and all EU countries discussed here are under the Excessive Deficit Procedure. This entails country-specific requirements regarding the size and speed of adjustment to reduce the overall deficit to the 3 percent of GDP Maastricht criterion, between 2012 (Latvia, Lithuania, Italy) and 2014 (Ireland, Greece, the United Kingdom; FY 2014/15 for the latter). Moreover, adjustment plans by Greece and Latvia are supported by EU/IMF financing.

Table 3.1.Advanced G-20 Economies: Projected Fiscal Balances Under the Toronto Declaration and Current National Plans(Percent of GDP)
Overall Fiscal BalanceCyclically Adjusted Balance1
201020132013201020132013
TorontoAuthorities’TorontoAuthorities’
WEODeclarationPlansWEODeclarationPlans
Australia2—4.6—2.30.3—4.4—2.40.4
Canada3—4.9—2.5—0.5—3.4—2.3—1.2
France—8.0—4.0—3.0—6.3—3.4—1.6
Germany-4.5—2.2—2.2—3.3—2.0—2.2
Italy—5.1—2.6—2.6—3.5—2.0—2.9
Japan4—9.6—7.6
Korea51.41.91.52.2
United Kingdom6—10.2—5.1—4.0—7.9—3.8—1.8
United States7—11.1—5.5—4.2—7.9—4.4—3.9
Average
(excl. Korea and Japan)8—9.1—4.5—3.4—6.6—3.7—3.0
Sources: National authorities, October 2010 WEO, and IMF staff estimates. The data are for general government, unless otherwise indicated.

The authorities’ plans are based on headline balances. These figures have been transformed into CAB figures by applying standard elasticities to revenues and expenditure with respect to the output gap. Output gap data are based on authorities’ information, where available; where unavailable, they are based on 2009 output gaps from WEO and the authorities’ information on real and potential growth rates from 2010 onwards. For transforming the overall balances under the Toronto Declaration into CAB terms, the WEO projected cyclical components were applied.

Target for 2013 is for federal government. The authorities also announced a target for the general government budget balance for 2012 (—0.8 percent of GDP).

Authorities’ plans for federal government.

In the case of Japan, the Toronto Declaration acknowledged that given its specific circumstances, the commitment to halve the deficit need not apply and therefore it is not included in the average under the Toronto Declaration columns. In the Fiscal Management Strategy released June 22, 2010, Japan has set out fiscal consolidation targets as follows: 1) halving primary balance deficit relative to GDP by FY 2015 at the latest, and achieving primary balance surplus by FY2020 at the latest; and 2) achieving stable reduction in the amount of public debt relative to GDP from FY2021.

WEO data are for central government, including social security fund.

Fiscal year targets for 2012/13 of 5.5 percent of GDP and for 2013/14 of 3.5 percent of GDP transformed into calendar year target.

Authorities’ plans for federal government for FY 2013. The annual adjustment over the period 2011—16 is envisaged at about 1.5 percent of GDP.

Weighted average based on 2009 PPP-GDP.

Sources: National authorities, October 2010 WEO, and IMF staff estimates. The data are for general government, unless otherwise indicated.

The authorities’ plans are based on headline balances. These figures have been transformed into CAB figures by applying standard elasticities to revenues and expenditure with respect to the output gap. Output gap data are based on authorities’ information, where available; where unavailable, they are based on 2009 output gaps from WEO and the authorities’ information on real and potential growth rates from 2010 onwards. For transforming the overall balances under the Toronto Declaration into CAB terms, the WEO projected cyclical components were applied.

Target for 2013 is for federal government. The authorities also announced a target for the general government budget balance for 2012 (—0.8 percent of GDP).

Authorities’ plans for federal government.

In the case of Japan, the Toronto Declaration acknowledged that given its specific circumstances, the commitment to halve the deficit need not apply and therefore it is not included in the average under the Toronto Declaration columns. In the Fiscal Management Strategy released June 22, 2010, Japan has set out fiscal consolidation targets as follows: 1) halving primary balance deficit relative to GDP by FY 2015 at the latest, and achieving primary balance surplus by FY2020 at the latest; and 2) achieving stable reduction in the amount of public debt relative to GDP from FY2021.

WEO data are for central government, including social security fund.

Fiscal year targets for 2012/13 of 5.5 percent of GDP and for 2013/14 of 3.5 percent of GDP transformed into calendar year target.

Authorities’ plans for federal government for FY 2013. The annual adjustment over the period 2011—16 is envisaged at about 1.5 percent of GDP.

Weighted average based on 2009 PPP-GDP.

Size and Speed of Adjustment: Authorities’ Plans and IMF Staff Projections

The planned size and speed of underlying adjustment appear to be broadly appropriate.

  • The advanced G-20 economies on average plan to improve their CAB by 1¼ percentage point annually during 2011-13 (Table 3.1), including through the unwinding of the 2009—10 stimulus.19 This magnitude of adjustment seems to be consistent with maintaining an adequate pace of economic recovery in line with WEO projections.20 For emerging economies, planned annual improvements in overall balances are lower (about 1 percent of GDP), reflecting mainly the currently smaller deficits. In general, the adjustment plans would strengthen the CAB from 5½ percent of GDP in 2010 (WEO estimate) to about 2½ percent of GDP in 2013 (simple average, Table 3.2). This is still significantly weaker than the pre-crisis CAB. The recovery is not full—in spite of the removal of crisis-related fiscal stimulus—because of the projected loss of potential output (and related revenues) owing to the recession (see the May 2010 Monitor); additional revenue loss related to the asset price cycle, some underlying increases in spending for entitlements, and the rise in interest payments as debt increases.

  • Many of the countries with large budget deficits stemming from the crisis tend to be the ones envisaging the largest frontloading (Figure 3.1a), with larger deficit reduction in 2011 than in the subsequent years (often following adjustments efforts already taken in 2010) (Figure 3.1b). In contrast, in the timing and speed of adjustment by the world’s largest economies for which market concerns are contained, projected growth prospects appropriately appear to weigh heavily. In the United States, the largest adjustment is expected to come in 2012 (see Figure 3.4 for authorities’ plans).21 Adjustment in Germany is foreseen in broadly equal steps (about ½ percentage point each year in CAB), while Japan’s plans translate into an adjustment of ½ percentage point for 2011, with only minor action in the ensuing years. China has also voiced a preference for a relatively gradual adjustment, although concrete medium-term plans still have to be specified.

Table 3.2.Fiscal Indicators of Crisis Impact and Planned Adjustment, 2007-13(Percent of GDP)
CrisisAdjustmentPlan in
AuthoritiesImpactPlanPercent of
(Change)(Change)Crisis
2010201312007-092010-131Impact
Overall balance2
Simple Average—6.9—2.8—7.24.056
Weighted Average—7.8—3.6—8.94.247
Public Debt3
Simple Average68.573.414.94.732
Weighted aAverage75.682.014.75.940
Cyclically Adjusted Balance2,4
Simple Average—5.4—2.4—4.63.064
Weighted Average—5.4—2.6—5.12.753
Source: IMF staff calculations based on authorities’ plans for 20 adjusting countries and October 2010 WEO.

2012 projection for overall balance is used for Lithuania, South Africa, and Turkey. 2011 debt projection is used for India.

For Ireland, the fiscal balances do not include the most recent issuance of promissory notes to recapitalize banks.

General government gross debt; for Japan, central and local government gross debt.

Not available for all countries; for calculations of the authorities’ planned CAB, see footnote in Figure 3.4.

Source: IMF staff calculations based on authorities’ plans for 20 adjusting countries and October 2010 WEO.

2012 projection for overall balance is used for Lithuania, South Africa, and Turkey. 2011 debt projection is used for India.

For Ireland, the fiscal balances do not include the most recent issuance of promissory notes to recapitalize banks.

General government gross debt; for Japan, central and local government gross debt.

Not available for all countries; for calculations of the authorities’ planned CAB, see footnote in Figure 3.4.

Figure 3.1Planned Timing of Adjustment, 2010-13

Sources: IMF staff estimates based on authorities’ plans for 20 adjusting countries and October 2010 WEO.

Notes: A frontloaded adjustment is defined as a higher adjustment in the overall balance in 2011 than in subsequent years, back-loaded if the adjustment in 2011 is less than in subsequent years. Outer years include fewer countries. For Ireland, the fiscal balances do not include the most recent issuance of promissory notes to recapitalize banks.

Headline balances adjust more rapidly than in the WEO, primarily reflecting more optimistic growth assumptions, at least in the advanced economies.

The plans, particularly in high debt advanced economies, assume faster real and nominal GDP growth, as well as lower interest payments (Table 3.3). In G-20 advanced economies, the headline balances would on average improve by about 1¾ percentage points per year, reflecting the closing of the output gap. These factors, as well as some allowance in the WEO projections for uncertainties regarding implementation, lead to a faster narrowing of deficits than under WEO projections, in particular in countries with relatively high fiscal deficits (Figure 3.2).

Over the medium term, in addition to fully implementing the current adjustment plans, sustained efforts will be needed to ensure a decline in debt ratios to prudent levels.

  • Based on the WEO growth projections, in advanced economies the average public debt ratio would increase by 35 percentage points to 108 percent of GDP from 2007 to 2015, of which two-thirds will be realized by end-2010 (Statistical Appendix Table 7 and Figure 3.3). Reflecting the divergence in adjustment plans and in economic growth, the evolution of debt ratio over the medium term varies considerably: in about half the sample, the debt ratio is projected to reverse its upward trend by 2013, but in one-third it would keep rising through 2015 (Figure 3.3). For emerging economies, the debt ratio is projected on average to resume a downward trend starting in 2010, although for some in this group, the debt ratio is projected to peak one or two years later (Latvia and Mexico in 2011; South Africa in 2012; the Russian Federation in 2013).22 Based on the authorities’ plans and their macroeconomic projections, debt developments would be somewhat more benign, in particular for high deficit countries (Figure 3.2).23

  • While current adjustment plans would start to put public debt on the right trajectory in most countries, typically the time horizon of the plans is too short to guarantee the medium-term fiscal trend that needs to be sustained, in particular by advanced economies. While this is understandable, only a few countries have committed to a concrete longer-term debt target, or have specified a path to reach targets pre-dating the crisis (as in the case of EU countries)—raising uncertainty about the ultimate goal of fiscal policy and the risk that countries may aim at stabilizing debt at high post-crisis levels.24 As noted in the May Monitor, stabilizing debt at high levels would raise real interest rates and lower potential growth over the longer run (see also Kumar and Woo, 2010). Repeating the illustrative scenario in the previous Monitor and determining by how much advanced economies would have to adjust their CAPB between 2010 and 2020 to bring back the public gross debt ratio to 60 percent of GDP by 203025 indicates that an improvement of 8¼ percentage points of GDP would be needed (Appendix Table 1). This is ½ percentage point lower than estimated earlier since the outlook for the CAPB in 2010 has improved (mostly because of the upward revision in the level of potential output for the United States). The planned adjustment by authorities by 2013 (in terms of CAPB) would currently cover, on average, 45 percent of this requirement (Figure 3.4c).

Table 3.3.Key Macroeconomic Assumptions Under Authorities’ Plans and in the WEO(Average 2010-13)
Real GDP GrowthNominal GDP GrowthInterest Payments
(Percent change)(Percent change)(Percent of GDP)
Authorities’WEOAuthorities’WEOAuthorities’WEO
plansplansplans
Total3.53.56.37.02.83.1
Advanced2.42.14.64.23.73.7
Low Debt4.23.86.76.41.41.4
High Debt2.52.34.44.03.64.0
Emerging4.85.08.410.02.22.7
Low Debt5.45.69.210.61.21.7
High Debt7.16.912.316.55.05.9
Sources: Country authorities’ announcements; and October 2010 WEO.Note: Simple averages.
Sources: Country authorities’ announcements; and October 2010 WEO.Note: Simple averages.

Figure 3.2.Authorities’ Plans versus Staff Projections, Selected Economies, 2007-13

(Overall balance and general government debt; Percent of GDP)

Sources: IMF staff calculations based on authorities’ plans; and October 2010 WEO.

Notes: Simple averages.

1High deficit economies are those with a general government deficit higher than 5 percent of GDP in 2009.

Figure 3.3.Change in Public Debt Outlook, 2008-15

(Percent of GDP)

Source: October 2010 WEO.

Note: Net debt for Japan.

Thus, in many countries, despite large adjustment efforts already in the pipeline, more is needed over the longer term. This reflects a combination of high debt levels, (e.g., Japan and Italy), large deficits (e.g., Ireland, Spain, the United States), and only gradual adjustment in the near term (e.g., Japan, Germany). Notable exceptions are Greece and the United Kingdom, where major short- and medium-term efforts are already under way (Figure 3.4c). While fiscal targets by Portugal and Lithuania appear also to entail much of the adjustment need, WEO projections show significantly smaller improvements in the CAPB because of the lack of specified measures in the outer years of these countries’ plans.26 For all countries, additional fiscal adjustment will be needed in the medium term because of pressures from health care and pension spending.

Composition of Adjustment

In most countries, concrete adjustment measures have not yet been enacted and in many, they need to be specified in more detail. Only about half the countries have adjustment plans with detailed information on proposed measures for the initial years. But even in these cases, measures have frequently not yet been enacted or the savings or additional revenues quantified. At this stage, plans often tend to include proposals that are difficult to assess in terms of their budgetary implications and the likelihood of their implementation. Exceptions are several countries that have frontloaded their adjustment, but even for these, the level of detail diminishes as the horizon is extended. As budgets for 2011 are being finalized across countries, greater clarity should emerge regarding measures for next year. Going forward, adjustment can also be seen as an opportunity to revamp government policies and operations. For example, improving expenditure efficiency, rationalizing and streamlining the public service, raising public labor productivity, and designing more efficient tax systems can all be seen as medium-term objectives to be supported by the consolidation measures requiring sustained effort.

Figure 3.4.Authorities’ Adjustment Plans and Required Adjustment until 2020

(Authorities’ planned annual changes; Percent of GDP)

Sources: IMF staff calculations and estimates based on authorities’ plans and October 2010 WEO projections.

Notes: For the United States and Ireland, the data are adjusted to exclude financial sector support recorded above the line. For the United States, data are for federal government in calendar years. For the United Kingdom, data are in fiscal years. For the Russian Federation, authorities’ plans refer to the federal government. CAB based on authorities’ information where available. Where unavailable, it is based on cyclical adjustment using standard elasticities and the output gap. Output gap is as estimated by authorities, or projections of the output gap (based on WEO 2009 output gaps and authorities’ projections for real GDP and potential GDP growth). Panel C compares the estimated adjustment needs in CAPB terms between 2010 and 2020 to achieve debt targets in 2030 (in general, 60 percent of GDP in advanced economies 80 percent of GDP net debt for Japan) and 40 percent in emerging economies; see footnote in Appendix Table 1 for more details) and the projected change in the CAPB (based on authorities’ information) between 2010 and 2015, or the latest year for which targets were announced.

Fiscal consolidation plans are tilted toward expenditure cuts. The majority of plans envisage mostly expenditure-based adjustments, with the rest a roughly equal mix between expenditure and revenue measures, or largely revenue measures (Table 3.4). Countries that have announced expenditure-based adjustments tend to be characterized by a combination of large consolidation needs and limited space for additional tax increases given their already high tax-to-GDP ratios (Figure 3.5). Nonetheless, some countries, in particular those with frontloaded adjustments (Portugal, Spain, the United Kingdom), have complemented their expenditure plans with substantive revenue measures, such as VAT rate increases, since relying exclusively on spending cuts would have been challenging given the size of the adjustment.27 China envisages budgetary improvements to come largely from the revenue side given its low tax ratio, and larger need for additional spending to widen social security coverage.

Overall, in advanced countries, expenditure is projected to remain constant in real terms in 2010—12 (Figure 3.6a), also reflecting the unwinding of the fiscal stimulus measures (of which about two-thirds were on the expenditure side). However, the primary spending ratio in 2014—when the output gap is projected to be all but closed—will still be larger than in 2007 by 2¼ percentage points,28 although this is mostly due to the projected decline in potential output related to the crisis.

Table 3.4.Planned Composition of Fiscal Adjustment
Deficit (2009)Largely

Expenditure-

based
Mix (broadly

equally-based)
Largely

Revenue-based
High deficit

(above 10% of

GDP)
Ireland

Japan

Spain

United Kingdom
Greece

India

United States
Medium deficit

(between 5 and

10% of GDP)
Portugal

Canada

France

Italy

Latvia

Lithuania

South Africa

Turkey
Russia
Low deficit

(below 5% of

GDP)
Australia

Germany

Korea

Saudi Arabia
MexicoChina
Sources: IMF staff estimates based on country authorities’ information.Note: Categorization is based on the entire adjustment period based on authorities’ announced plans (including 2010 where applicable). Largely expenditure (revenue)-based reflects that adjustments rely on expenditure (revenue) measures in cumulative terms of more than 60 percent of total adjustment. “Broadly mixed” reflects expenditure/revenue measures of about 40-60 percent. In individual years, the composition may be different (e.g., Germany, Portugal, and Turkey have a mixed adjustment in the first years, while relying more on expenditure in the outer years).
Sources: IMF staff estimates based on country authorities’ information.Note: Categorization is based on the entire adjustment period based on authorities’ announced plans (including 2010 where applicable). Largely expenditure (revenue)-based reflects that adjustments rely on expenditure (revenue) measures in cumulative terms of more than 60 percent of total adjustment. “Broadly mixed” reflects expenditure/revenue measures of about 40-60 percent. In individual years, the composition may be different (e.g., Germany, Portugal, and Turkey have a mixed adjustment in the first years, while relying more on expenditure in the outer years).

Figure 3.5.Adjustment Composition versus Revenue-to-GDP Ratios

Note: The figure shows the minimum, maximum, and average for each category. Revenue-based category includes only China.

Simple averages.

Figure 3.6.Planned General Government Real Expenditure and Revenue Growth

(Percentage change)

Sources: 2008—10 are based on October 2010 WEO; 2011—14 are based on country authorities’ plans.

Note: Simple average. Outer years include fewer countries.

Spending cuts are more tilted toward the wage bill, size of civil service, and social transfers than public investment, which is appropriate in line with evidence on the effect of composition of spending cuts and the effectiveness of fiscal adjustment.29 Many advanced countries have announced a public sector wage freeze or a reduction of the wage bill over time (Canada, Greece, Ireland, Italy, Latvia, Portugal, Spain, the United Kingdom). This is consistent with the comparatively high level of this spending category in those countries, surpassing 11 percent of GDP pre-crisis (Figure 3.7). Advanced economies also have a greater focus on social transfer cuts than emerging economies, reflecting the higher share of these expenditures in their budgets (e.g., in Germany, more than one-third of the announced consolidation measures is estimated to come from social spending cuts).30 Reduction in defense spending is under consideration in Germany and the United States.31 The United Kingdom has set out its proposals to reduce future defense spending by 8 percent from 2011—12 to 2014—15.

Figure 3.7.Wage Bill and Social Protection Expenditure, 2008

(Percent of GDP)

Sources: Eurostat; and IMF staff estimates.

Note: Data are for 2008 or latest year available.

On the revenue side, measures affecting direct taxation dominate, which may raise concerns for the impact on growth. Of the announced and already implemented revenue measures, personal income tax (PIT), corporate income tax (CIT), and social security contributions (SSC) accounted for nearly half of all revenue measures, while increases in the value-added tax (VAT) (ranging from 1 to 4 percentage points in Europe) and excise taxes represent about one quarter (in terms of number of measures and not necessarily budgetary impact for which information is not available). Some countries also announced the adoption or extension of green taxes (Germany, Ireland, Korea, South Africa), as well as export taxes on commodities (the Russian Federation). To the extent that higher direct taxes discourage labor supply and investment, consolidation could weigh on growth prospects.32 On the positive side, half of the envisaged tax measures, in particular those affecting PIT and CIT, aim at widening the tax base, rather than just increasing tax rates, potentially reducing the negative impact of higher direct taxes on growth. In addition to tax policy measures, some countries (Greece, India, Italy, Korea, Latvia, Portugal, the United Kingdom) are also planning to enhance their revenue administrations to reduce tax evasion. This is important in terms of both equity and efficiency considerations, and the large existing margins to improve compliance.

Most countries, including nearly all those with large deficits, have announced measures to protect vulnerable groups from the impact of the crisis, but these efforts have been undertaken in a piecemeal manner. None have plans to undertake a comprehensive reform of social protection networks to enhance their efficiency and effectiveness. Even in many countries that have comprehensive social protection schemes that predate the financial crisis, there is a need to improve targeting of benefits, including through enhanced means-testing, to make sure that resources reach those most in need (Figure 3.8; Appendix 3). In addition to addressing the human costs of the crisis, this will help increase the long-term sustainability of adjustment efforts.

Figure 3.8.The European Union: Targeting of Non-Age-Related Social Spending, 2007

(Percent of GDP)

Source: Eurostat.

Medium-Term Adjustment Needs and Structural Reforms

To address medium-term fiscal gaps, entitlement reforms are critical, particularly of health care systems.

  • Pension reforms have already been enacted in many advancedeconomies, so that pension spending in these economies is projected to rise on average by about 1 percentage point of GDP over the next two decades, compared to about 3 percentage points of GDP without such reforms.33 Further reforms are needed, however. First, the projected spending increase remains sizable: future public pension spending increases over the next twenty years amount to 8¾ percentage points of GDP in net present value terms. Second, spending pressure may turn out to be stronger, unless at the same time reforms are implemented to boost productivity and employment growth. The latest major reform was enacted by Greece in July 2010, including gradually raising the retirement age and cutting benefits. In France, parliament recently passed the increase of the minimum retirement age from 60 to 62 years.

  • Little has been done to control the rise in health care spending inadvanced economies (Box 3.1), with expenditure estimated to surge by 3½ percentage points of GDP by 2030. On the positive side, awareness of this issue is increasing and various commissions to develop options have been set up (e.g., in France, Germany, Korea).

  • Where reform discussions are already under way, plans focus on trimming the pharmaceutical bill (Greece, Ireland, Spain, the United Kingdom). Germany’s reform proposals include a reversal of the reduced health care contribution rate for stimulus purposes and short-term measures to cap expenditure. The health care reform passed in the United States expands coverage, while the cost-reduction implications remain uncertain as they depend on future implementation of cost containment policies.

Reform of Fiscal Institutions

Fiscal and budget institutions are being strengthened in many countries. Germany had intended to adopt a constitutional structural budget balance rule even before the crisis, and this was implemented in June 2009. The United Kingdom has set up an Office for Budget Responsibility (OBR), and draft legislation has been presented to parliament to make the OBR permanent. The government has also established a fiscal mandate to guide the consolidation plans: to balance the cyclically adjusted current budget by the end of the rolling five-year forecast period. This mandate is supplemented by a target to place public sector net debt as a share of GDP on a downward path by 2015/16. Japan has recently announced a medium-term fiscal framework, including a pay-as-you-go rule. The United States adopted the statutory Pay-As-You-Go-Act of 2010, although some important programs were exempted, in some cases temporarily.34 The U.S. President has also set up a bipartisan fiscal commission charged with developing options to reach primary balance by 2015. At the EU level, measures to improve the effectiveness of the EU’s fiscal governance framework are making progress (Box 3.2). Countries that have come under market stress have also made reforming their fiscal institutions a cornerstone of their exit strategies. Four of the six high deficit countries plan to adopt a fiscal rule (Table 3.5), among them three that faced market concerns (Latvia, Lithuania, Greece). Greece’s new Fiscal Responsibility and Management Act extends the time-horizon and scope of fiscal policymaking, introduces a top-down sequence to budget preparation, tightens expenditure controls, and increases parliamentary scrutiny of the budget. In Latvia and Lithuania, a fiscal responsibility law and a new deficit rule, respectively, are under preparation. So far, the share of countries planning new independent fiscal agencies is smaller (about 25 percent) but there is room for a considerably greater role for such institutions (Table 3.5).

Table 3.5.Number of Countries with Fiscal Rules and Fiscal Agencies or Plans for Their Adoption
Fiscal RulesFiscal Agencies
WithWithoutPlans for

Adoption
WithWithoutPlans for

Inception
Total91157133
Of Which:
High Deficit Countries 1564382
High Debt Countries 2673682
Countries with Plans

Beyond 2013
563651
Source: IMF staff estimates.

Overall deficit in 2009 is higher than 7 percent of GDP.

Public debt-to-GDP ratio in 2009 greater than 60 percent of GDP for advanced economies (net debt for Japan) and greater than 40 percent for emerging economies.

Source: IMF staff estimates.

Overall deficit in 2009 is higher than 7 percent of GDP.

Public debt-to-GDP ratio in 2009 greater than 60 percent of GDP for advanced economies (net debt for Japan) and greater than 40 percent for emerging economies.

Box 3.1.Advanced Economies: The Outlook for Public Health Spending

Containing the growth of public health spending is a key fiscal challenge for many advanced economies. IMF staff project that public health spending in the European Union will rise by an average of 3 percentage points of GDP over 2011—30, under the assumption that health care costs will continue to increase in line with recent trends (Figure 1).1 IMF staff projections also point to substantial increases in spending in other advanced countries, including the United States (4½ percentage points of GDP from 2011 to 2030). Renewed reform efforts are therefore required to contain the increase in public health spending.

Figure 1.Projected Increases in Health Spending 2011—30

(Percent of GDP)

Source: IMF staff calculations.

Recent cost-containment efforts in Europe have focused on pharmaceuticals and are unlikely to have a major effect on the long-term outlook for spending. In the United Kingdom, plans include the introduction of value-based pricing for pharmaceuticals. Germany instituted a three-year freeze on prices of pharmaceutical covered by statutory health insurance and increased the rebate that drug manufacturers are expected to pay.2 France slashed reimbursement rates for a large number of drugs and imposed price caps on generics. Italy announced plans to centralize pharmaceutical procurement, reduce prices of generics, and introduce a tendering system for generics. Ireland cut prices of off-patent drugs and unveiled plans to introduce reference pricing and generic substitution of pharmaceuticals. Spain introduced decrees strengthening reference-value pricing and lowering prices of pharmaceuticals not included in the system of reference pricing. Greece is introducing a price-referencing system, cutting prices on certain drugs, and expanding the list of medications that are not reimbursed. These developments are projected to have positive effects in the short term, but are unlikely to have a major effect on the growth of spending over the longer term, especially given the modest share of pharmaceutical outlays in total public health outlays (about 15 percent in the OECD countries).

Despite the 2010 health care reform in the United States, public health spending is likely to continue to consume a growing share of the federal budget. Under the 2010 reform, Medicare payment cuts would be at least partly offset by the expansion of eligibility and the provision of insurance subsidies, leaving net savings from the reform highly uncertain. Supplementing Congressional Budget Office projections for federally mandated spending with estimated spending increases for subnational governments, IMF staff forecast that general government health spending will rise by 4½ percentage points of GDP over the next 20 years. There are substantial upside risks to these projections: under less optimistic assumptions on Medicare payment reductions and the cost of subsidies, health care outlays could be 1 percentage point of GDP higher in 2030, although there is the possibility that more effective therapies (e.g., gene therapy) may make a dent in the trend cost increases.

More fundamental reforms are needed to contain the growth of spending while ensuring broad access to high quality health care. Measures will be needed to strengthen supply-side incentives or reduce the demand for public health services. Reimbursing providers using case-based payment or global budgets, rather than fee-for-service, are important supply side options for many countries. Reducing tax expenditures on private health insurance and increasing cost sharing could also be considered to rationalize demand. Past reforms—including the introduction of budget caps in a number of European countries and managed care in the United States in the 1990s—provide valuable lessons for future reforms, although the appropriate policies will be country-specific (IMF, 2010b).

1 In contrast, the baseline projection of the European Commission’s Aging Report (European Commission, 2009) envisages an increase in public health spending of 0.7 percentage point of GDP, based on the optimistic assumption that technological progress will not contribute to rising health care costs.2 The recent German reform also included increases in revenues by increasing social contributions from 14.9 to 15.5 percent of wages and increasing statutory co-payments from 1 to 2 percent of income.

However, there is considerable scope to strengthen fiscal and budget institutions further to support the consolidation process. In particular, most G-20 governments need to improve the breadth, depth, and timeliness of fiscal reporting, forecasting, and risk management to ensure that their consolidation efforts are to be based on a comprehensive, up-to-date, and robust understanding of the fiscal position. To aid consolidation planning, fiscal frameworks need to set more specific, time-bound targets for one or more broad fiscal aggregates and be supported by more comprehensive and binding medium-term budget frameworks. For example, in the United States, the president’s draft budget includes detailed medium-term revenue and spending projections, with the latter clearly presenting quantified estimates of the administration’s policy priorities. However, neither 10-year projections of federal outlays of the Office of Management and Budget nor those in the Congressional budget resolution provide binding multiyear restrictions on total spending. To ensure that those plans are implemented, budget preparation and approval processes need to follow a top-down sequence. The annual budget preparation process in most G-20 countries follows some kind of notional top-down procedure but, in some countries, its impact on the final budget outcome is mitigated by widespread earmarking of revenue, fragmentation of budget decision-making, and frequent resort to supplementary budgets.

Box 3.2.The European Union: Reforming Fiscal Governance

Intense sovereign stress in some euro area countries triggered a formal debate on strengthening Europe’s fiscal framework, under the aegis of the European Council’s Task Force on Economic Governance. The crisis revealed serious flaws affecting the operation of both the preventive and corrective aspects of the Stability and Growth Pact (SGP). First, the preventive provisions of the SGP—supposed to encourage broadly balanced budgets over the cycle—have largely been ineffective. As a result, insufficient buffers were built in good times. Second, weak governance undermined both preventive surveillance and the enforcement of corrective provisions, reflecting reluctance by the EU bodies to hold member states accountable for their fiscal commitments and obligations. Third, the fiscal framework lacked crisis management and resolution capacities, a gap that has now been temporarily filled with the creation of the European Financial Stability Facility (EFSF).

Various views were expressed on the role of binding instruments and procedures effectively tying the hands of national governments. For example, the ECB suggested applying sanctions (including the loss of voting rights in European bodies) in the preventive arm of the SGP, making these sanctions quasi-automatic, and creating a politically independent fiscal agency to improve surveillance. The IMF had proposed to “shift the main responsibility for enforcement [of the excessive deficit procedure] away from the Council [to minimize] the risk that narrow national interests interfere with effective implementation of the common rules.”(IMF, 2010c).

The Task Force in its report of October 22, 2010 made a number of recommendations to reform economic governance in the EU which were endorsed by the European Council at its end-October meeting. The main elements of the reform include the following:

  • The “Excessive Deficit Procedure” can be launched regardless of the deficit when debt levels are both excessive (above 60 percent of GDP) and not declining sufficiently rapidly.

  • Financial sanctions are introduced under the preventive arm of the SGP, and can be initiated by the European Commission with the possibility of a Council veto with a qualified majority; sanctions are increased under the corrective arm (ranging from non-interest bearing deposit to fines).

  • Surveillance is broadened to include assessment of macroeconomic imbalances and vulnerabilities with the possibility of the Council placing a member in an “excessive imbalance position.”

  • The “European semester” entailing an ex-ante peer-review of budget proposals, will take effect from January 2, 2011, allowing for an assessment of budgetary measures and structural reforms.

  • Recommendations for the use of independent fiscal agencies to provide analysis, assessments and forecasts on domestic fiscal policy matters to reinforce fiscal governance at the national level.

  • To safeguard the financial stability of the euro area, the task force will consult on a limited Treaty change to establish a “permanent crisis mechanism” but without modifying the “no bail-out clause” of the treaty. Such a mechanism would replace the European Financial Stability Facility. Proposals will be prepared by the Council’s task force by December.

Overall, the reforms tackle many weaknesses of the current governance framework but the role of the Council in some key steps in the decision-making process remains broadly unchanged. In particular, the “Excessive Deficit Procedure” and sanctions under the corrective arm can only be initiated through a decision by a qualified majority of the Council, in line with the current situation.

Medium-Term Fiscal Trends in Low-Income Countries

The medium-term fiscal outlook in LICs appears favorable. Primary balances are projected to strengthen by 1¼ percentage points of GDP during the next five years, with the average public debt-to-GDP ratio gradually returning to the pre-crisis level (40 percent). On an annual basis, this implies a tightening of less than ¼ percentage point per year. This consolidation encompasses a conservatively projected increase in revenue and also accommodates continued real spending growth over the medium term to meet priority needs. About a third of the projected improvement in the primary balance is expected to come from higher revenues arising from recovery of growth. The remainder is expected to come from new revenue measures and efforts to curtail nonpriority spending. Real spending growth, with a median annual increase of about 4 percent, is expected to be somewhat slower than observed in the pre-crisis years and reflects nonrenewal of crisis-related discretionary stimulus and the need to build buffers in more vulnerable countries. In countries with less fiscal space, efforts should center on mobilizing additional revenue or donor inflows to create room to increase priority spending.

There is some variation by region and by country groups. In sub-Saharan Africa and in low-income countries where IMF-supported programs are in place, the projected fiscal improvement is somewhat lower and about half the improvement reflects cyclical factors related to the recovery (Figure 3.9). In a quarter of the countries in sub-Saharan Africa, the medium-term projections incorporate significant fiscal expansion. These two country groups have debt ratios in 2010 that are lower, on average, than the LIC-wide average. The expected improvements in structural balances are larger in other regions, especially for LICs in Latin America and the Caribbean. The fiscal adjustment for LICs in Asia, Europe, and the Middle East is less driven by cyclical improvements.

Although LICs have weathered the crisis relatively well, they are vulnerable to a range of risks, including a slowdown in global growth and cuts in donor grants. For example, if growth was lower by 2 percentage points on average over the rest of 2010 and 2011—12, fiscal revenues would be lower and deficits could be ½ percent of GDP higher on average (assuming no adjustment of spending). Under these circumstances, debt ratios would no longer be on a declining path and would be 3 percentage points higher on average in 2015 (Figure 3.10). If the lower growth shock is compounded by a reduction in grants—say, by 10 percent relative to the baseline projection or around % percent of GDP on average—and LICs do not offset this with spending cuts, debt ratios would begin to deviate more sharply from the baseline. Countries with more favorable debt projections could absorb the shocks and allow their deficits to widen. However, some high-debt and deficit LICs would need to tighten their fiscal stance to offset the impact of the shocks. Cuts in expenditure might set back progress toward meeting the Millennium Development Goals.

Figure 3.9.Low-Income Countries: Projected Improvement in Fiscal Balances, 2011-15

(Median change; Percentage points of GDP)

Source: October 2010 WEO.

Figure 3.10.Low-Income Country Debt Paths

(Percent of PPP-weighted GDP)

Source: IMF staff estimates.

Note: Weighted GDP based on 2009 PPP-GDP.

In light of the risks and given large infrastructure and social needs, fiscal policies in LICs should continue to aim at strengthening revenue collections. The need to address infrastructure gaps and social spending needs while rebuilding fiscal buffers makes it especially important to pursue revenue-enhancing reforms in LICs. In spite of progress made over the past decade, revenue-to-GDP ratios remain relatively low in many LICs. There is also scope to improve the efficiency of spending, including by better targeting subsidies. Of course, for countries where larger adjustment is projected, rebuilding fiscal buffers while protecting social and investment spending will be challenging without additional donor support.

The six non-G-20 economies (Greece, Ireland, Latvia, Lithuania, Portugal, Spain) are among the ones with the largest adjustment needs as identified in the May 2010 Fiscal Monitor. The data used in this section are drawn from the authorities’ publicly announced plans, as available at end-September. Cyclically adjusted balances (CABs) are computed based on authorities’ projections of the output gap or, if not available, potential growth.

China has not published medium-term targets, while Saudi Arabia has established a medium-term target for expenditure but not the fiscal balance. Argentina, Brazil, and Indonesia do not anticipate significant medium-term consolidation given the limited impact the crisis had on their budgets.

An exception is Germany, which has a legal requirement to reduce the federal structural deficit to no more than 0.35 percent of GDP by 2016 in broadly equal annual steps.

This analysis of the CAB is based on staff analysis of the headline balances included in the plans and of the potential growth rates or output gaps provided by the authorities (Table 3.2). For more details on data conventions, see IMF (2010d).

The fiscal projections included in this Monitor—which, as noted, are consistent with the October 2010 WEO projections—envisage a slightly lower adjustment for these countries (about 1 percentage point of GDP), reflecting uncertainties on the implementation of some measures.

While data on the United States’ plans reported here assume a small fiscal adjustment in 2011 (Figure 3.4), they do not yet account for the stimulus package announced in mid-September. Fully including those measures, the 2011 fiscal deficit would remain broadly unchanged (for more details, see Chapter 1).

For Lithuania, IMF staff project the debt ratio to continue rising quite significantly through 2015, reflecting a large positive interest rate growth differential and primary deficits. However, authorities’ plans, announced only until 2012, envisage a smaller debt increase.

Of the 20 analyzed countries here, only 5 have published debt projections until 2015. Thus, Figure 3.2 focuses on comparisons until 2013.

The advanced G-20 economies announced in the Toronto Declaration that they would stabilize or reduce their public debt ratios by 2016. Within this group, in national plans only the United Kingdom has announced targeting a falling public sector net debt-to-GDP ratio from 2015/16. Australia’s medium-term strategy includes the goal to improve the government’s net financial worth over the medium term, but without a specified target and date. However, in Australia gross and net debt are even now among the lowest in advanced countries. Among other advanced economies, Portugal has announced plans to stabilize public debt at 85 percent of GDP in 2012. Among emerging economies, India and Indonesia have announced specific debt targets.

Or stabilize them at the end-2012 level, in the case of gross public debt ratios below 60 percent. Details about the features of this scenario (in which the CAPB is kept constant during 2021–30) can be found in the May Monitor.

For the United Kingdom, IMF staff also project a somewhat higher fiscal gap to the required adjustment than shown in Figure 3.4c, but nevertheless a significant portion would still be completed by 2015 if plans are implemented as announced.

Based on experience with past consolidations, there is evidence (IMF, 2010f) that expenditure-based fiscal consolidations tend to be more durable and less harmful to growth than revenue-based ones, largely because spending-based adjustments are typically accompanied by monetary stimulus. However, it is also the case that beyond a certain threshold of adjustment, relying solely on spending reduces the likelihood of success (Baldacci and Gupta, 2010). In addition, sound fiscal governance and structural reforms are important in consolidations that achieve debt targets without excessive adverse impact on growth (for example, see European Commission, 2007; Kumar, Leigh, and Plekhanov, 2007).

Based on October 2010 IMF staff projections for advanced economies (weighted average).

See IMF (2010d) for details on the announced type of measures. Little information is available on the estimated budgetary impact, however.

The potential impacts that fiscal adjustment may have on income distribution as well as measures that can help limit the effect, such as more targeted expenditure, are reviewed in Appendix 3.

For the United States, saving measures on defense spending in the draft budget are about 0.3 percent of GDP. Moreover, it is assumed that overall security-related spending would drop from 5¾ percent of GDP in FY2010 to 4½ percent of GDP in FY2015. For Germany, the savings from the planned military reforms are currently estimated at around 0.1 percent of GDP in 2013–14.

Myles (2009a, b) reviews the literature on the link between tax structure and economic growth and shows that higher broad-based consumption and property taxes are less harmful to growth than income taxes; and that corporate income tax can be particularly distortionary and impede long-run growth. However, in addition to tax efficiency, policy also needs to consider equity and implementation aspects of taxes.

Spending would increase by an additional 0.5 percentage points between 2030 and 2050 for these economies. For an analysis on pension reform options and their macroeconomic impact, see Chapter 5. For more details on projected health care and pension increases as well as reforms undertaken in both areas, see IMF (2010b).

For other recent reforms regarding fiscal rules, see the May 2010 Monitor, Box 7.

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