VIII Policy Implications
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 3 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

The purpose of this chapter is to draw summary policy implications for countries that receive significant flows of remittances based on what the various facts, models, and arguments contained in the preceding chapters have added to our understanding of remittances and the role they play in a country’s economy. The specific findings of the preceding chapters can be organized around three main points:

The purpose of this chapter is to draw summary policy implications for countries that receive significant flows of remittances based on what the various facts, models, and arguments contained in the preceding chapters have added to our understanding of remittances and the role they play in a country’s economy. The specific findings of the preceding chapters can be organized around three main points:

  • First, the proper measurement of remittances is essential to estimating their impact on the macro-economy, and hence for making sound policy.

  • Second, remittances carry a number of potential benefits, but each is matched with a potential cost.

  • Third, the challenge is to design policies that allow these benefits to flow to households and the economy while limiting or offsetting any counterproductive side effects.

Regarding the proper measurement of remittances, the variable known as workers’ remittances in data sources such as the World Development Indicators database (World Bank, 2006) is the best measure of the private, unrequited transfers that economists have in mind when modeling remittances and ascertaining their economic impact. This classification is also a good fit with the changes that the IMF Committee on Balance of Payments Statistics and the Advisory Expert Group on National Accounts have proposed in order to properly classify, collect, and track remittance flows. The analysis in Chapters 2 and 3 indicates that the economic and statistical properties of the category workers’ remittances in the balance of payments differ significantly from those of employee compensation and migrants’ transfers, so that combining these three transfers into a single measure of remittances, as is common practice in the literature, can lead to invalid conclusions about the correlation of remittances with other variables. In turn, conclusions based on the improper measurement of remittances can lead to non-optimal policy decisions.

Regarding the potential benefits and costs of remittances, there are at least three reasons to be optimistic about remittances’ economic impacts: remittances are private, dependable, and substantial. However, the systematic study of the remittances phenomenon conducted in previous chapters yields an important caveat to this optimism. The aspects of remittances that generate economic benefits are also the sources of potential pitfalls that must be understood and managed. The following discussion illustrates how each benefit of remittances is paired with a potential problem.

To begin with, remittances directly and indirectly improve the welfare of individual households by lifting families out of poverty and insuring them against income shocks, such as those generated from business cycle fluctuations or natural disasters. Chapter 4 shows that although the exact motivations for remittances are nearly impossible to discern, the available survey evidence on the uses of remittances reveals that remittances primarily fund consumption, and the econometric analysis of remittances across countries over time strongly suggests that they are compensatory rather than opportunistic transfers. The theoretical analysis in Chapter 6 illustrates that the increased consumption of goods and leisure that can be attributed to receipt of remittances is the result of optimal decision making by households and leads to significant increases in welfare even after other effects are netted out. The simulation results from Chapter 6 show the consumption-smoothing effect to be robust to different economic structures and tax regimes, and Chapter 7 presents empirical evidence that remittances are indeed associated with lower output volatility. Consequently, the compensatory nature of remittances facilitates consumption smoothing and decreases the volatility of both consumption and output, directly benefiting risk-averse households.

On the other hand, the analysis in Chapter 5 suggests that remittances are not necessarily associated with an increase in, or a more efficient allocation of, domestic investment. The relative permanence of remittance flows plays an important role in determining whether they are used for consumption rather than investment. But other effects on investment may also be present. For instance, remittances alter incentives to work. Remittance recipients rationally substitute unearned remittance income for labor income, which must be earned through the expenditure of effort. The labor-leisure trade-off, for example, is clearly illustrated in the model of Chapter 6, in which the optimal decision of households leads, in both of the calibrated economies, to greater use of leisure over labor after remittances are introduced. Since labor and capital are complementary goods in production, this may negatively affect the rate of capital accumulation in the economy as a whole. Finally, the analysis further indicates that the effects of remittances on the efficiency of investment depend on their impact on financial development and the marginal cost of financial intermediation, which could be positive or negative.

Although it is difficult to gauge the size of the incentive effect on work and investment, this effect does help explain two additional findings. First, the survey evidence on the uses of remittances presented in Chapter 4 shows that remittances primarily fund consumption and the accumulation of housing and real estate assets rather than investment in business capital. Second, the estimates presented in Chapter 7, which use properly measured remittance data and an improved instrument for remittances, show that remittances have no statistically significant effect on GDP growth.

A further main benefit of remittances is that they improve the sustainability of government debt. The analysis of Chapter 5 and the theoretical model in Chapter 6 provide the underlying rationale for this conclusion: significant inflows of remittances can directly or indirectly increase a government’s revenue base, thereby reducing the marginal cost of raising revenue for debt service purposes. Chapter 7 also discusses how remittances may lead to additional household saving and illustrates how traditional debt sustainability analysis might be conducted in regard to remittance-dependent economies. The evidence in these chapters suggests that remittances enable a government to service existing debt with less distortionary costs to the economy or to increase the level of debt while maintaining the same level of distortions. In either case, the presence of remittances leads to reduced country risk. Governments should, of course, use any fiscal space created by remittance inflows in constructive ways. Suggested courses of action are discussed in further detail later in the chapter.

As with those of households, however, remittances may also alter government incentives in a non-growth-friendly way. In particular, a potential risk from remittances is that they may reduce the government’s incentive to maintain fiscal policy discipline. The loosening of the government’s intertemporal budget constraint may lead to the issuance of additional public sector debt to finance expenditure increases or tax reductions that are not growth enhancing.1 The empirical evidence presented in Chapter 7 suggests that governments take advantage of the fiscal space afforded by remittances by consuming and borrowing more. But just because remittances enable the public sector to carry more debt, that does not mean that it should. Nor should remittances be used as a reason to postpone needed fiscal consolidation.

A final benefit of remittances is that they constitute a source of financing in an economy’s balance of payments. For example, to the extent that they provide financing for current account deficits, remittances can facilitate the increases in domestic consumption mentioned previously. Yet the benefit to the current account is matched by a potential cost in the form of Dutch disease effects. Chapters 5 and 7 discuss the relationship between remittance inflows and real exchange rates, and the empirical evidence presented suggests that remittances are positively correlated with real exchange rate appreciation. Hence, there is some evidence of remittance-driven Dutch disease effects in remittance-receiving countries. (As the discussion in Chapter 7 indicates, however, this is an area in which additional research is needed.) To the extent that Dutch disease effects are present in a particular remittance-receiving economy, policymakers must find ways to offset the effects of remittance flows on the equilibrium real exchange rate or to compensate the economy’s traded goods sector for the loss of competitiveness that it suffers from the equilibrium real exchange rate appreciation.

In sum, the previous seven chapters, taken together, produce a picture of remittances that is much more nuanced and complete than is currently obtainable from individual studies of the subject, one that imparts a better understanding of some of the puzzles observed in the data. For example, perhaps the greatest question regarding remittances is why they have not clearly contributed to the economic growth and development of recipient countries despite the large size and persistent nature of remittance flows. Part of the answer is found in the evidence that remittances are compensatory in nature and are simply not intended to be used in ways that directly promote economic growth. Furthermore, the compensatory nature of remittances implies that they may alter work and investment incentives, thereby weakening their potential to increase economic growth. Given this more complete and nuanced view of remittances, it is not surprising that it has been difficult to detect a positive impact of remittances on growth. A second, and more important, benefit of possessing a complete understanding of remittances and their macroeconomic impacts is that this knowledge provides a sound basis for policy advice. The next section takes up the main policy recommendations emanating from this more-nuanced view of remittances.

Policy Implications of Remittances

Unfortunately, the task of policymakers becomes more difficult when the complexities of remittances are taken into consideration. It is clear that remittances improve the welfare of households that receive them and, as such, should be encouraged (or, at a minimum, remittances policy should be neutral, neither encouraging nor discouraging them). The main challenge, stated in general terms, is to design policies that promote remittances and increase their benefits while limiting or offsetting any counterproductive side effects. There are several ways in which policy can be designed to meet this challenge.

First, with regard to tax policy, remittances should not be taxed directly. Doing so may cause a decline in remittance activity or increase the transaction costs of remitting as some portion of the flow migrates from formal to informal channels. Any reduction in net transfers to recipients reduces remittances’ ability to alleviate poverty, causing a large loss in welfare. Instead, the evidence indicates that consumption-based taxation, already a staple in many emerging and developing countries, provides the correct incentive structure for maximizing the benefits of remittances to households while simultaneously permitting the government to finance its budgetary expenditures with the least-distortionary impact on economic activity.2 An overreliance on labor income taxation may exacerbate the labor-leisure trade-off incentives of remittances and encourage the use of inflation as an indirect tax, which is also distortionary. Remittance-receiving countries that rely too heavily on labor taxes should be advised to shift toward consumption-based tax systems in order to mitigate possible negative effects on economic growth, minimize the level of distortions generated by fiscal and monetary policy, and benefit from any tax-induced increase in investment that may result from the inflow of remittances into the economy.

Second, any loosening of the government budget constraint due to remittances must be used to channel remittances into activities that promote long-run economic development while preserving their poverty-reducing effects in the short run. It is not obvious that these two objectives are compatible, and indeed they may not be, if measures to divert remittance flows to specific productive uses significantly reduce the amount of remittance flows allocated to the alleviation of poverty. Nevertheless, poverty alleviation and growth promotion can be complementary to the extent that growth promotion involves public expenditure. This is an example of the constructive use of the fiscal space referred to in the previous section.

One way that governments can use public expenditure to enhance remittances’ development impact is to improve public infrastructure, both physical infrastructure and public institutions as well. This policy recommendation lends support to the emphasis on institutional reform in Sing and others (2005) and Krueger (2004) and echoes the rest of the migration and development literature, which finds that poor physical infrastructure and poor governance discourage private investment.3 But the complex nature of remittances lends additional urgency to this argument: the receipt of remittances exacerbates the negative impact of poor infrastructure on investment. Stated in positive rather than negative terms, the more remittances a country receives, the higher the quality of the country’s public infrastructure must be in order to induce a given amount of investment from individuals. In short, the receipt of remittances raises the hurdle that governments must overcome in order to facilitate growth. Using improvements in public infrastructure and institutions to increase the return to private investment is crucial in light of the difficulty in finding a robust positive effect of workers’ remittances on economic growth.

However, remittances may pose a moral hazard problem by reducing the political will to enact policy reform. Remittances that insure the public against adverse economic shocks, including those caused by poor economic policies and poorly performing institutions, may reduce households’ incentives to pressure their governments to implement the reforms and improvements necessary to facilitate economic growth. At the same time, the receipt of remittances loosens fiscal constraints on governments, putting off any day of reckoning instigated by a faulty policy stance. In other words, remittance flows act as a buffer between households and the governments that serve them, creating the potential for a negative political economy effect. Remittances can therefore delay needed upgrades to public infrastructure by reducing both public demand for them and the likelihood of a crisis that will make such reforms necessary.

In the extreme case,4 remittance-dependent countries could become mired in a “remittances trap” of the following sort. The households in a particular country receive a significant quantity of remittances, which lifts most of them up to an acceptable standard of living. Private investment in the country is low because of poor investment opportunities due to low-quality physical infrastructure and missing or malfunctioning institutions, so economic growth in the country is also low. The country’s government spends its revenues on nonproductive consumption (perhaps patronage) and maintains a high debt-to-GDP ratio, which is financed at a high interest rate, either domestically or through external debt. Individuals who are frustrated with the lack of opportunities at home migrate, rather than becoming politically active, and send remittances back to support those who stay behind. Those who remain also lack the incentive to put pressure on the government to reform, because remittances partly compensate them for the negative consequences of the government policy. Therefore, the country persists in a state characterized by low growth, poor economic policy, and high remittances.

Thus a third and broader policy recommendation arising from the political economy effects of remittances is that outside engagement may be required to prompt governments to undertake needed reforms when a country receives a significant inflow of remittances. In particular, international institutions have an important role to play in convincing remittance-receiving countries to undertake or accelerate necessary reforms. Currently, a review of governance and institutional quality is routinely undertaken as a part of IMF Article IV consultations. The incentive effects of remittance flows suggest that such reviews are of particular importance in remittance-receiving economies.

A final, and correlated, lesson to take away is that a one-size-fits-all reform strategy to promote growth and development is likely to be counterproductive. Instead, a nuanced approach to reform that differentiates among countries based on their reliance on remittances will likely be more successful in achieving its targets. This recommendation echoes those of the World Bank (2005), Hausmann, Rodrik, and Velasco (2005), and Rodrik (2006), who argue that growth and development strategies should involve a combination of diagnosis and policy design tailored to alleviate the most significant constraints on growth across countries. In countries that receive remittances, the constraints on growth will likely require a different policy reform package than in countries that do not receive such flows. A complete understanding of how remittances affect the macro-economy will allow for a tailoring of policy recommendations to preserve the positive benefits of remittances while minimizing their negatives.

Getting these policy prescriptions correct is imperative, since labor migration and remittances have a long history, and it is doubtless that such activity will continue throughout the world well into the future. Globalization and the aging of some developed economy populations will ensure that demand for migrant workers remains robust for years to come. Hence, the volume of workers’ remittances is likely to continue to grow, and with it, the challenge of unlocking the maximum societal benefit from these transfers.

References

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1

Similarly, the inflow of remittances may finance current account deficits and hence postpone a devaluation of the currency.

2

Care must be taken when implementing consumption taxes to exempt basic necessities such as food and clothing, in order to avoid adverse effects on poverty alleviation.

3

See Acemoglu, Johnson, and Robinson (2001) and Easterly and Levine (2003) for additional support on the role of institutions in promoting economic performance.

4

This does not describe any particular remittance-receiving country.

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