A. Strategies for Adjustment
36. Achieving large fiscal adjustments will require a variety of measures, with emphasis likely on the expenditure side. This section summarizes recent work by IMF staff on spending and revenue measures and institutions in support of fiscal adjustment (IMF 2010c, IMF 2010d). In advanced economies, high pre-existing tax burdens may limit scope to raise tax rates without adverse effects on economic efficiency.24 This, together with the fact that stimulus measures consisted primarily of spending increases, as well as the need to offset the projected increase in age-related spending, implies a higher reliance on expenditure measures. Nevertheless, given the magnitude of the needed consolidation in many advanced economies, fiscal adjustment will likely require revenue measures as well. Moreover, in emerging economies, where the scope for improving revenues is substantial, reforms could also include tax measures, especially as many emerging economies envisage increased spending on stronger and better-targeted social programs.
Expenditure Measures
37. Regarding non-age-related spending, a possible strategic goal would be to freeze per capita spending in real terms over the medium term. Such a strategy would generate structural savings of 3 to 3½ percentage points of GDP in the advanced economies over the next 10 years. This approach helped underpin successful consolidations in Belgium (1983–89), Denmark (1982–86), Finland (1993–2000), Israel (1980–83), and Sweden (1993–2000). Specific measures to support the spending freeze should focus on rationalizing wages and improving targeting of subsidies, transfers, and expenditures on social benefits. Subsidy spending on energy products absorbs about 1 percent of world GDP (Appendix 5).
38. Health care constitutes the key challenge in stabilizing age-related spending pressures. Health care spending is projected to rise by 3½ percentage points of GDP in 2010–30 in advanced economies due to aging and technology-induced cost pressures (Figure 16). Reforms will need to contain the growth of spending, while ensuring broad access to high-quality health care. Specific measures will be required to strengthen supply-side incentives or to reduce the demand for public health services. In general, supply-side measures—such as global budgets for provider reimbursement and evaluation of the cost-effectiveness of medical treatments and technology—are most effective at containing costs. On the demand side, measures include increasing cost sharing to discourage moral hazard and reducing tax expenditures from subsidies for private health insurance. In several emerging economies, the challenge differs and is focused on expanding health care coverage in a fiscally sustainable manner.
Projected Increases in Pension and Health Spending
Source: IMF staff projections; see IMF 2010c.39. Regarding pensions, in many advanced economies legislated reforms are expected to moderate the effect of aging on spending, but further measures are needed. Pension expenditure is currently projected to rise by 1 percentage point of GDP over the next 20 years (Figure 16). To stabilize pension spending relative to GDP, reforms should focus on increases in statutory retirement ages, although benefit reductions and increases in contributions may also be needed. A two-year increase in the statutory retirement age phased over the next two decades would be sufficient to stabilize pension spending as a share of GDP at its 2010 level by 2030 (the same result could be achieved by cutting benefits by 15 percent or by a 2 percentage point increase in payroll taxes).25
Revenue Measures
40. Boosting revenues in an efficient manner requires strengthening broad-based taxes on relatively immobile bases and increasing externality-reducing taxes. Table 11 summarizes possible revenues that could be raised through relatively efficient measures. There is substantial scope for improving the revenue performance of the VAT in almost all countries (i.e., reducing the VAT “policy gap”), including by eliminating exemptions and reduced rates. Many countries have room to significantly increase revenues from tobacco and alcohol excises and fuel taxes. Pricing greenhouse gas emissions—by taxing carbon or auctioning emissions permits—could raise large sums. Property taxes also are an efficient source of revenues with a benign impact on growth. Altogether, these relatively efficient measures could yield an estimated 2.8 percentage points of GDP (on a weighted average basis) in G-7 economies. Additional revenues could be raised by introducing a VAT or by raising the standard rate where it is low. For instance, introducing a VAT in the United States, and doubling the very low VAT rate in Japan, could raise 4.5 percent and 2.6 percent of GDP, respectively, in those countries. While there is also scope for stronger income taxation, in part to address equity objectives, efficiency concerns loom larger there. Nevertheless, there may be room for base-broadening measures to raise revenues here as well. Tax-policy reforms have contributed to sustained revenue increases in past episodes of adjustment (Box 6).
Past Episodes of Sustained Fiscal Revenue Increases
Past sustained, substantial increases in tax revenues have typically been supported by comprehensive tax policy and/or administration reform. In a sample of 44 advanced and emerging economies over the past three decades, it is possible to identify 29 episodes in 20 countries where tax revenues increased by more than 3 percentage points of GDP over 2 consecutive years. In 14 of these cases involving 10 countries, the increase of tax revenues was sustained broadly without reversal for 10 years (i.e., through the cycle). Natural resources-related revenues accounted for four of these cases, two in Indonesia and one each in Norway and the United Kingdom. The 10 other cases involved 7 countries, and revenue gains were the result of “regime change,” or comprehensive tax policy reforms. These included: introduction of the VAT in Portugal and Spain in 1986 and in Iceland in 1989; comprehensive base-broadening tax policy measures in Italy in 1997 and 2004 (while lowering some rates); and far-reaching tax administration reforms in Peru during the 1990s. In the cases when adjustment was long-lasting, 90 percent of the increase in revenues was accounted for by increases in income taxes (50 percent) and consumption-based taxes (40 percent). In other countries such as Ireland in the 1990s, tax policy reforms reduced rates or narrowed bases and led to lower revenues.
41. Strengthening tax compliance, including through better international cooperation, would also contribute to higher revenues. This requires renewed efforts to tackle aggressive tax planning, evasion, and fraud. International collaboration in tax information exchange and transparency are important in this regard. There is significant scope to increase revenues through more effective efforts to thwart tax evasion. For example, VAT evasion is estimated to average 0.7 percent of GDP in advanced economies (IMF, 2010c).
Estimated Potential Revenue Increases in Selected Advanced G-20 Economies 1/
(In percent of GDP)
Figures do not include any increases from base broadening or rate increases in income taxes.
Based upon raising rates for alcohol and tobacco to the 2006 average level of each tax across the six countries shown, where existing rates are below the mean. For illustrative purposes, the demand elasticity is assumed to be zero.
Based on raising gasoline and diesel rates by 10 cents per liter in each case.
Raising the U.S. tax to 30 cents per liter would raise an additional 0.6 percentage point of GDP in the United States.
Increase revenue from property taxes to yield average ratio to GDP in Canada, the United Kingdom, and the United States.
For Japan, estimate of increased revenue from doubling VAT rate to 10 percent; for the United States approximation of receipts from introduction of broad based federal VAT at 10 percent.
Estimates for European countries derived by weighting allocation of emission rights based upon per-country levels of emissions in 2007; a small proportion of these revenues would represent double-counting of the carbon emission externality correcting portion of fuel excises.
Estimated Potential Revenue Increases in Selected Advanced G-20 Economies 1/
(In percent of GDP)
| Country | Reduce VAT Policy Gap by Half | Tobacco and Alcohol Excises 2/ | Fuel Excises 3/4/ | Property Taxes 5/ | Total | VAT at 10 percent Rate 6/ | Full Auctioning/ Taxation of Carbon Emissions 7/ | Total |
|---|---|---|---|---|---|---|---|---|
| France | 3.8 | 0.1 | 0.3 | 1.0 | 5.1 | n/a | 0.2 | 5.3 |
| Germany | 2.4 | 0.2 | 0.3 | 1.0 | 3.8 | n/a | 0.6 | 4.5 |
| Italy | 3.1 | 0.3 | 0.3 | 1.0 | 4.6 | n/a | 0.5 | 5.1 |
| Japan | 0.3 | 0.9 | 0.3 | 1.0 | 2.4 | 2.6 | 0.0 | 5.0 |
| United Kingdom | 3.3 | 0.0 | 0.2 | 0.0 | 3.5 | n/a | 0.5 | 4.0 |
| United States | 0.0 | 0.3 | 0.6 | 0.0 | 0.9 | 4.5 | 0.8 | 6.1 |
| Unweighted average | 2.1 | 0.3 | 0.3 | 0.7 | 3.4 | … | 0.4 | … |
| PPP GDP weighted average | 1.1 | 0.3 | 0.4 | 0.4 | 2.2 | … | 0.6 | … |
Figures do not include any increases from base broadening or rate increases in income taxes.
Based upon raising rates for alcohol and tobacco to the 2006 average level of each tax across the six countries shown, where existing rates are below the mean. For illustrative purposes, the demand elasticity is assumed to be zero.
Based on raising gasoline and diesel rates by 10 cents per liter in each case.
Raising the U.S. tax to 30 cents per liter would raise an additional 0.6 percentage point of GDP in the United States.
Increase revenue from property taxes to yield average ratio to GDP in Canada, the United Kingdom, and the United States.
For Japan, estimate of increased revenue from doubling VAT rate to 10 percent; for the United States approximation of receipts from introduction of broad based federal VAT at 10 percent.
Estimates for European countries derived by weighting allocation of emission rights based upon per-country levels of emissions in 2007; a small proportion of these revenues would represent double-counting of the carbon emission externality correcting portion of fuel excises.
Estimated Potential Revenue Increases in Selected Advanced G-20 Economies 1/
(In percent of GDP)
| Country | Reduce VAT Policy Gap by Half | Tobacco and Alcohol Excises 2/ | Fuel Excises 3/4/ | Property Taxes 5/ | Total | VAT at 10 percent Rate 6/ | Full Auctioning/ Taxation of Carbon Emissions 7/ | Total |
|---|---|---|---|---|---|---|---|---|
| France | 3.8 | 0.1 | 0.3 | 1.0 | 5.1 | n/a | 0.2 | 5.3 |
| Germany | 2.4 | 0.2 | 0.3 | 1.0 | 3.8 | n/a | 0.6 | 4.5 |
| Italy | 3.1 | 0.3 | 0.3 | 1.0 | 4.6 | n/a | 0.5 | 5.1 |
| Japan | 0.3 | 0.9 | 0.3 | 1.0 | 2.4 | 2.6 | 0.0 | 5.0 |
| United Kingdom | 3.3 | 0.0 | 0.2 | 0.0 | 3.5 | n/a | 0.5 | 4.0 |
| United States | 0.0 | 0.3 | 0.6 | 0.0 | 0.9 | 4.5 | 0.8 | 6.1 |
| Unweighted average | 2.1 | 0.3 | 0.3 | 0.7 | 3.4 | … | 0.4 | … |
| PPP GDP weighted average | 1.1 | 0.3 | 0.4 | 0.4 | 2.2 | … | 0.6 | … |
Figures do not include any increases from base broadening or rate increases in income taxes.
Based upon raising rates for alcohol and tobacco to the 2006 average level of each tax across the six countries shown, where existing rates are below the mean. For illustrative purposes, the demand elasticity is assumed to be zero.
Based on raising gasoline and diesel rates by 10 cents per liter in each case.
Raising the U.S. tax to 30 cents per liter would raise an additional 0.6 percentage point of GDP in the United States.
Increase revenue from property taxes to yield average ratio to GDP in Canada, the United Kingdom, and the United States.
For Japan, estimate of increased revenue from doubling VAT rate to 10 percent; for the United States approximation of receipts from introduction of broad based federal VAT at 10 percent.
Estimates for European countries derived by weighting allocation of emission rights based upon per-country levels of emissions in 2007; a small proportion of these revenues would represent double-counting of the carbon emission externality correcting portion of fuel excises.
B. Institutional Arrangements
42. Strong fiscal institutions can play an important role in supporting the requisite fiscal adjustment. They can improve fiscal performance by providing a clear medium-term orientation, highlighting the need for sustainable policies, and raising the cost of deviating from stated fiscal objectives. Robust institutions are particularly important during fiscal retrenchment, when tensions between short-term, sectoral interests and long-term, collective aims often are at their highest.
43. In the area of budgetary institutions, there is room for improvement in many countries. These institutions include practices, procedures, and mechanisms that govern the preparation, passage, execution, and monitoring of the budget over the short and medium terms as well as the legal requirements. While advanced G-20 economies tend to have stronger budgetary institutions than emerging economies, they also face larger adjustment challenges. Recent IMF staff analysis identifies reform needs in particular in three areas. First, the breadth, depth, and timeliness of fiscal reporting and analysis of risks surrounding fiscal forecasts could be improved in many countries. Second, more clearly articulated fiscal objectives, and more comprehensive and binding medium-term budget frameworks with greater independent scrutiny, are needed. And third, a greater use of top-down budgeting—enforcing clearer prioritization across sectors and hard budget constraints—and more robust contingency arrangements are needed to ensure that plans are effectively implemented through the annual budget process.
44. Moreover, a medium-term budgetary framework, supported by numerical fiscal rules, can help guide policy and anchor expectations regarding sustainability. Comprehensive, stable, and transparent medium-term fiscal objectives, against which governments can be held accountable, provide a stable anchor for policy decisions and raise the costs of deviating from the consolidation path. Formalizing such medium-term fiscal objectives as permanent fiscal rules can signal a strong commitment to the consolidation effort. That fiscal rules confer benefits is reflected in their widespread introduction over the past two decades.26 In 1990, only 7 countries had fiscal rules; by 2009, 80 countries used them (including national and supranational rules covering at least the central government) (Figure 17). While the crisis has strained existing rules, many countries are adopting new rules or strengthening existing ones as part of their exit strategies (Box 7).
The Use of Fiscal Rules around the World 1/
Sources: IMF (2010d); and IMF staff calculations.1/ As of early 2009. Includes national and supranational rules covering at least the central government.The Use of Fiscal Rules around the World 1/
Sources: IMF (2010d); and IMF staff calculations.1/ As of early 2009. Includes national and supranational rules covering at least the central government.The Use of Fiscal Rules around the World 1/
Sources: IMF (2010d); and IMF staff calculations.1/ As of early 2009. Includes national and supranational rules covering at least the central government.45. Looking ahead, strong fiscal institutions can enhance the credibility of consolidation plans, which could mitigate any adverse short-term impact of fiscal withdrawal on activity. A credible growth-oriented package of fiscal reforms could have a positive effect on investment and on potential output through expectations of lower interest rates and lower future taxes. To illustrate this, Figure 18 shows simulations of the impact of a hypothetical, supply-enhancing, five-year fiscal consolidation program under different assumptions as to its initial credibility: (i) a somewhat unrealistic case with full credibility from the onset; and (ii) cases where full credibility is delayed by two, three, and four years, as agents remain unconvinced until progress in implementing the package is demonstrated.27 The impact of the credibility of the consolidation package on output and investment is measured as deviations from the baseline projection—which itself incorporates the dampening effect that current fiscal consolidation plans would have on activity. The key insights from the simulations are that lack of credibility undermines the positive investment and output effects to the point of eliminating them; conversely, strong credibility could mitigate to a large extent the negative demand effects prompted by fiscal consolidation.
Fiscal Consolidation Packages Designed to Raise Potential Output under Different Assumptions about Credibility 1/
(Percent deviation from baseline)
Source: April 2010 WEO, Chapter I, based on the GIMF model simulations.1/ The medium-term effects of fiscal consolidation in the advanced economies will depend on the type of expenditure and tax instruments that are used. Some illustrative simulations with the GIMF model show that fiscal policies designed to raise potential output (lower taxes on capital and labor and higher taxes on consumption goods) could be successful in raising world output in the short run if they resulted in large downward revisions in expectations of future levels of debt and taxes on capital and labor. The simulations have been constructed under different assumptions about credibility, to show the implications if agents are skeptical initially that the policies will be adhered to in the future.Fiscal Consolidation Packages Designed to Raise Potential Output under Different Assumptions about Credibility 1/
(Percent deviation from baseline)
Source: April 2010 WEO, Chapter I, based on the GIMF model simulations.1/ The medium-term effects of fiscal consolidation in the advanced economies will depend on the type of expenditure and tax instruments that are used. Some illustrative simulations with the GIMF model show that fiscal policies designed to raise potential output (lower taxes on capital and labor and higher taxes on consumption goods) could be successful in raising world output in the short run if they resulted in large downward revisions in expectations of future levels of debt and taxes on capital and labor. The simulations have been constructed under different assumptions about credibility, to show the implications if agents are skeptical initially that the policies will be adhered to in the future.Fiscal Consolidation Packages Designed to Raise Potential Output under Different Assumptions about Credibility 1/
(Percent deviation from baseline)
Source: April 2010 WEO, Chapter I, based on the GIMF model simulations.1/ The medium-term effects of fiscal consolidation in the advanced economies will depend on the type of expenditure and tax instruments that are used. Some illustrative simulations with the GIMF model show that fiscal policies designed to raise potential output (lower taxes on capital and labor and higher taxes on consumption goods) could be successful in raising world output in the short run if they resulted in large downward revisions in expectations of future levels of debt and taxes on capital and labor. The simulations have been constructed under different assumptions about credibility, to show the implications if agents are skeptical initially that the policies will be adhered to in the future.Fiscal Rules—Recent Developments
In some countries, the adoption of new fiscal rules was already under way prior to the crisis or was decided during the crisis. As these rules have entered into force, in some cases with transition regimes, they will provide guidance to fiscal policy making and set constraints during the consolidation path.
Austria: The reform of the Federal Budget Law, adopted by constitutional law in 2007, includes the requirement for the government to set up rolling 4-year expenditure ceilings that are extended annually by another year. These ceilings apply to the federal government and contain a cyclical component. This rule took effect with the 2009 budget.
Germany: A new structural balance rule was enshrined in the constitution in June 2009. After a transition period, starting in 2011, it will take full effect in 2016 for the Federal government and 2020 for the states. The rule calls for a structural deficit of no more than 0.35 percent of GDP for the federal government and structurally-balanced budgets for the Länder.
Hungary: In November 2008, Hungary adopted a primary budget balance rule and a real debt rule as part of the adoption of a Fiscal Responsibility Law. The rules will take effect in 2012. Transition rules call for a reduction of the budget deficit (in percent of GDP) and limit real expenditure growth in 2010 and 2011. A new independent fiscal institution was also established to monitor fiscal developments.
Mexico: To promote savings, caps on accumulation of revenues in oil funds were removed for 2010. Consideration is being given to (i) introducing a new structural rule to reinforce savings at the top of the cycle and further reduce debt ratios; and (ii) improving medium-term expenditure planning.
Several other countries are considering adjusting or strengthening existing rules-based frameworks or adopting new rules as part of their exit strategies. Examples include:
France: A high-level commission was set up to assess the introduction and the design of a new fiscal rule to redress budgetary imbalances over the medium term.
Poland: The new Public Finance Act, which entered into force in January 2010, has defined corrective measures to be taken in case the thresholds under the debt rule are breached. Moreover, the government announced its intention to implement a temporary fiscal rule limiting the growth rate of discretionary expenditure to CPI inflation plus one percentage point until the medium-term objective (structural deficit of 1 percent of GDP) is reached. At that point a permanent rule—yet to be determined—will come into effect.
Serbia: A working group has been set up to study options for introducing a fiscal rule over the medium term and for the transition period. Expenditure ceilings are being considered for the transition phase.
Turkey: The government is currently drafting legislation to adopt a budget balance rule to facilitate fiscal adjustment and reduce public debt. The proposed rule includes an adjustment mechanism for deviations of real GDP growth from a trend. The government plans to adopt the rule this year so that it can become effective for 2011.
There are important exceptions, however, notably carbon pricing, which could raise revenues in a relatively efficient manner even in countries with a high tax-to-GDP ratio.
IMF (2010c) discusses in more detail the pension reforms undertaken in the advanced economies and specific measures and considerations to achieve the reduction of benefits.
See IMF (2010d) for an analysis of the role that fiscal rules have played in past consolidations, experiences with fiscal rules worldwide, and a discussion of design features of fiscal rules, in particular with a view to support credible exit strategies from the crisis.
The figure is drawn from Chapter 1 of the April 2010 WEO. The simulations were prepared by the IMF Research Department using the Global Integrated Monetary and Fiscal Model. The fiscal packages are designed to produce a deficit reduction (as a ratio to GDP) relative to the WEO projections baseline of 3 percentage points for the United States and Japan, and 2 percentage points in the euro area. Illustratively, the simulated fiscal packages include cuts in current government expenditure, consumption tax hikes, and tax cuts in capital and labor taxes—designed to raise potential output.
