Abstract

After the onset of the global financial crisis, economies in CESEE came under pressure to correct external and internal imbalances. By now, much of the external adjustment has taken place, via increases in private and public savings and, mainly, through declines in investment relative to GDP—a process that has come with high unemployment in many cases.2

After the onset of the global financial crisis, economies in CESEE came under pressure to correct external and internal imbalances. By now, much of the external adjustment has taken place, via increases in private and public savings and, mainly, through declines in investment relative to GDP—a process that has come with high unemployment in many cases.2

The global financial crisis of 2008-09 forced sharp, pro-cyclical fiscal adjustments on many CESEE countries, typically triggered by a sharp tightening in financing conditions and the reassessment of longer-term growth prospects. Fiscal adjustment is not yet complete, with significant consolidation needs remaining in several economies, many of them in Southeastern Europe (see below).

The quality of fiscal adjustment is the focus of this chapter, taking a longer-term perspective. As most countries in CESEE have emerged from the crisis and its aftereffects, this is an opportune time to take stock of the structural quality of their budgetary systems, how these have changed during adjustment, and of reform needs that remain. While there are several studies reviewing individual countries’ experiences with fiscal adjustment, and also cross-cutting studies on expenditure and revenue reforms, notably in the IMF Fiscal Monitor (2013, 2014), this study takes a regional perspective, looking for common traits and lessons that can be drawn from CESEE’s experience.

The chapter focuses on the structural quality of budgets. At its core are questions such as: do revenue systems limit disincentives to work, save, and invest? Does government spending promote productive activities—particularly the accumulation of physical and human capital—or does it finance mostly unproductive transfers? The focus is not on cyclical budgetary management, which is covered extensively in IMF bilateral surveillance, notably Article IV reports.

A. How Growth Friendly Are Budgets in CESEE?

Budget structures in CESEE resemble more those of Advanced Europe than of other Emerging Economies, despite significantly lower GDP levels. On the spending side, transfers and public consumption tend to be higher than among peers, on the revenue side, CESEE governments rely disproportionately on social security contributions and consumption taxes. Overall, most CESEE countries entered the global financial crisis with relatively growth unfriendly budget structures.

CESEE Budget Structures Compared to Peers

Budgetary systems in CESEE are young. Many of their features were put in place during the economic transition from socialism in the early 1990s. This (relative) youth has been both a blessing and a curse. On the one hand, CESEE countries could design many budgetary elements from scratch—notably on the revenue side—and in so doing could draw on international experience. On the other hand, legacy issues burdened the transition, such as loss-making state owned enterprises, overburdened social security systems, and excessive public employment. In some cases, these issues inhibit fiscal policy to this day.3

Public expenditure levels in Central and Eastern Europe (CESEE) are high and resemble more those of Advanced Europe than of other Emerging Economies (Figure 2.1).4 Despite significantly lower income levels, total spending as a share of GDP is close to Western European standards, reflecting arguably historical reasons, geographic and cultural proximity, and a similar understanding of the role of government. There are some differences within CESEE: the Baltic countries and Turkey tend to spend somewhat less than Central (CEE) and South-Eastern (SEE) European countries, and also less than countries in the Commonwealth of Independent States (CIS). However, these differences pale compared to the discrepancies with public sectors in Latin America or Emerging Asia, both of which absorb much smaller shares of GDP.

Figure 2.1.
Figure 2.1.

Public Spending and Income, 2014

(Structurally adjusted)

Sources: IMF World Economic Outlook database; and IMF staff calculationsNote: simple cross-country averages (as in all figures).

The similarity with Advanced Europe shows up as well in similar revenue and, especially, spending structures (Figure 2.2).

  • Expenditures. Transfers form a sizable portion of government spending, reflecting well developed social safety nets and high outlays for public pensions (Box 2.1). For public consumption—i.e., spending on goods and services—and the public sector wage bill, expenditure levels in CESEE are also close to those of Advanced Europe. The exception is public investment, where CESEE economies outspend Advanced Europe by a substantial margin (as a share of potential GDP). Disaggregating spending by sub-region shows that Turkey differs from the rest of CESEE, with relatively smaller shares in transfers and public consumption, in line with its smaller overall spending levels. Also in the Baltic countries, transfers are below the CESEE average.

    Revenues. The discrepancies with Advanced Europe are larger on the revenue side. CESEE governments tend to raise a higher share of revenue from consumption taxes—i.e. value added tax (VAT) and excises—than their western European counterparts. By contrast, they raise less from direct taxes on personal (PIT) and corporate income (CIT). For taxes on personal income and property, the revenue yield in CESEE is less than half compared to that in Advanced Europe.5 Consumption taxes are an important revenue source especially in Southeastern Europe, where yields are almost double those of Advanced Europe. Turkey raises a relatively small share of revenue from social security contributions, in line with its lower level of transfers.

Figure 2.2.
Figure 2.2.

Budgetary Structures, 2014

(Structurally adjusted)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

Public Pension Spending and Pension Sustainability1/

The challenges for pension systems in Emerging Europe (EE) resemble those in Advanced Europe (AE). Increasing life expectancy and falling fertility rates have triggered rapid population aging. In the EE EU Member States—where comparable data exist from the European Commission’s Ageing Report—the share of the working age population is expected to decline rapidly. While currently about 1.5 workers support one pensioner, this is expected to be only one worker per pensioner in 2060 (for AE countries, the number of workers per pensioner will fall from 1.9 to 1.4).

Progress with pension reform in Emerging Europe compares favorably with Advanced Europe. Many EE countries began to introduce pension reforms starting in the early 2000s. Although the path and pace of reforms differ across countries, most countries have reduced pension benefits, restricted early retirement, and increased the retirement age. As a result of these reforms, in most EE countries the net pension deficit is projected to be less than 2 percent of GDP by 2060. At the same time, public pension spending is projected to fall by ¼ of a percentage point until 2060.6

A major concern is social sustainability of the pensions system. A key element of pension reform has been the reduction in pension benefits through parametric reforms. As a result, the level of pensions—already lower compared to AE—will decline further. Relative to wages, pension benefits are projected to fall on average by 10 percentage points until 2060. While such developments are unavoidable to render public pensions financially sustainable, in a few countries, the benefit ratio and gross replacement rate are projected to fall below 20 percent in 2060. This looks unrealistic and raises concerns about intergenerational equity.

To ensure adequate retirement incomes in the future, EE policymakers should strive to raise the effective retirement age and encourage private savings. Aligning the retirement age with life expectancy alone could improve the net pension balance by about 0.6 percentage points. Increases in public pension contributions may also be called for in individual cases. The development of private pension savings schemes should be encouraged, to complement public pensions for higher-earning workers.

ch02ufig1
Source: European Commission, The 2015 Aging report.
1/ This box was prepared by Yan Sun

Differences in budget structures can reflect policy preferences, but also different structural characteristics of the underlying economies. For example, an open economy would typically raise a larger portion of revenues from (indirect) trade taxes than a closed economy. To separate out the structural component, Figure 2.3 compares the CESEE’s actual (average) budget structure with a model-based, “predicted” structure—that is, the budget one would expect from a country with identical structural characteristics. The model-based budget is computed from cross-country regressions covering 76 advanced and emerging economies (Annexes V and VI for details). The regressions suggest that per-capita GDP is the most important correlate of budget structures, with richer economies collecting more revenue from income taxes, and spending a relatively higher share of GDP on the public sector wage bill and on transfers. Other important correlates are total GDP, openness, population density, age structure, and resource wealth.

Figure 2.3.
Figure 2.3.

Actual vs. Model-Implied CESEE Budgets

(Structurally adjusted, percent of potential GDP)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

Public spending in CESEE is generally higher than the various structural characteristics suggest—but especially so on transfers, public consumption, and other, unclassified expenses. On the revenue side, CESEE countries use particularly heavily social security contributions and consumption taxes. As CESEE, advanced Europe spends more on transfers than its structural characteristics suggest, but—in contrast to CESEE—not on public consumption. On the revenue side, CESEE’s disproportionate reliance on consumption taxes is not shared by Advanced Europe. Differences in public investment and personal income tax between Advanced Europe and CESEE are largely explained by structural characteristics.

What Makes a Budget Growth Friendly?

Context

The remainder of this chapter analyzes the link between CESEE’s budgetary structures and long-term growth. Before advancing, some remarks are in order to place the analysis in context.

  • First, supporting growth is only one objective of fiscal policy. In particular, fiscal policy also pursues social and distributional objectives that may or may not correlate with growth—the link is complex. There can be conflicts: for instance, a shift from direct to indirect taxes reduces disincentives for work and savings, but it also decreases the amount of income redistribution through the tax system. Similarly, cuts in transfers can encourage labor participation but might worsen equity. That said, well-designed fiscal packages can mitigate such trade-offs (Cournede et al., 2014).7 For example, if the proceeds of a regressive yet growth-enhancing tax reform are used to finance productive spending, for example on education or health, the outcome may be higher growth and lower inequality (IMF, 2014b).

  • Second, growth friendliness has a long- and a short-term dimension. In the short term, the impact of policies on aggregate demand can be more important than the structural aspects discussed here. Cuts in transfers, for example, can be detrimental to aggregate demand, even though they may improve labor market outcomes in the longer term. A discussion of short-term demand stabilization is beyond the scope of this chapter.

  • Third, not only taxation and spending levels matter for growth but also the quality of government policy and institutions. On the revenue side, this includes issues such as tax expenditures and the quality of tax administration. On the expenditure side, spending efficiency is critical. Box 2.2 reports results for public infrastructure, health, and education. They point to relatively strong educational outcomes in CESEE relative to the amount spent on public education. This is less the case though for health and public infrastructure (the latter with the exception of the Baltic countries). Thus, CESEE’s relative overspending on public investment may compensate in part for lower spending efficiency.

Theory

Economic theory offers some insights into how budgetary policies can support growth (Anschauer, 1989; Barro and Sala-i-Martin, 1992; Mendoza et al., 1997).

For government revenues, theory suggests that, at an aggregate level, taxation of income tends to be more harmful to growth than taxation of consumption.

  • Taxation of capital income reduces the return on savings and investment, thus discouraging domestic investment, foreign direct investment and productivity improvement (Hall and Jorgenson, 1967; Lee and Gordon, 2005). With capital being fairly mobile, high capital taxes can also drive corporate activity across borders absent international cooperation. Such tax arbitrage by multinational companies can be especially detrimental for emerging economies (De Mooij and Ederveen, 2008; Dharmapala, 2014; Crivelli, Keen and De Mooij, 2015).

  • Labor taxes can reduce both the demand for and supply of labor. Social security contributions can be especially harmful to employment if they interact with the withdrawal of social transfers upon taking up work, creating so called “employment traps”—that is, high effective marginal tax rates at the lower end of the income distribution (Blundell el al. 1998; Eissa and Liebman 1996; Pissarides 1998).

  • By contrast, broad-base consumption taxes discourage neither savings nor employment. Some taxes—such as environmental taxes—can even improve resource allocation and correct market failures (IMF, 2015a; Woo et al., 2013; Agnello and Sousa, 2012). At the same time, indirect taxes tend to be regressive. Sector-specific taxes, by contrast, can be especially distortionary and growth unfriendly.

In line with these arguments, a series of papers by the Organization for Economic Cooperation and Development (Johansson et al., 2008; Arnold, 2008) has developed a “tax and growth ranking”, according to which taxation of corporate profits has the most adverse impact on growth, followed by labor taxation. By contrast, recurrent taxes on immovable property are the least distortive tax instrument (Box 2.3), followed by broad-base consumption taxes, particularly VAT.

Public Spending Efficiency1/

“Spending efficiency”—that is, achieving policy objectives with minimal public expense—is critical for high-quality fiscal policy. This box assesses CESEE countries’ public spending efficiency based on the “efficient frontier approach”. The “efficient frontier” maps an output variable—e.g., average PISA test scores—against an input variable—education spending. The frontier is formed by a linear combination of the countries that achieve specific outcomes at the lowest cost.8 A country’s spending efficiency is summarized by an “efficiency score,” that is, the ratio of the frontier-level of expenditure to the country’s level. The score is equal to one if a country is at the frontier. A score of less than one indicates that the country has room to save by improving efficiency.

This box analyzes spending efficiency in three key areas: public infrastructure, health, and education. Outcomes for CESEE countries vary greatly across these three areas.

  • Infrastructure. Most CESEE countries have not only poorer infrastructure than Advanced Europe, they also lag Advanced Europe as regards the efficiency of public investment provision. The exception are the Baltics, which are close to the efficient frontier. By contrast, SEE countries have most room to improve.

  • Health. Health spending in CESEE countries is also less efficient than in Advanced Europe. Further, the health expenditure efficiency in CESEE countries is at the lower end of emerging market economies. Some SEE countries have higher efficiency with a very low level of expenditure. CIS countries have the most room to improve efficiency.

  • Education. By contrast, education expenditure in CESEE countries is relatively efficient. Turkey (and to a lesser extent the SEE region) is close to the efficient frontier, with relatively low levels of education spending. Many Baltics and CEE countries have similar educational scores as Advanced Europe, but achieve this with a significantly lower education expenditures.

ch02ufig2
ch02ufig2
Source: Public capital stock and infrastructure indicator data are provided by FAD 9FAD notes Center for International Comparison (2013). World Economic Forum (2014), OECD (2014), WEO, World Development Indicators (2014) as sources. Health expenditure, life expectancy, and government education expenditure data are from World Development Indicators. PISA (Program for International Student Assessment) scores are from OECD (2012).Note: The sample includes all countries whose data are available. The box plots on right panels show 25th, 50th, and 75th percentile, with the whiskers showing minimum and maximum values. For smaller groups, CESEE, SEE, Baltics, CIS, and Turkey, only the ranges are presented.
1/ This box was prepared by Jiae Yoo.

On the expenditure side,

Taxes on Property1/

Property taxes are widely regarded as an efficient and equitable means of raising revenue, but with a revenue potential that is largely untapped in many countries. Property taxes generally yield relatively modest revenue, particularly in developing economies, but there are also large disparities across countries that signal a potential for enhanced utilization (Norregaard, 2013). In CESEE, revenue collection2/ from property taxes in 2012/13 averaged 0.7 percent of GDP, similar to that in developing countries, but less than half of that in advanced economies. There is no evidence either of any CESEE catch-up to advanced European countries in property tax collection. Since 1990, collection has increased by about ½ a percentage point of GDP in both country groups.

ch02ufig3

Revenue from Property Taxes, 1990-2013

(In percent of GDP)

Property Tax Revenue (2012/13)

article image

Recurrent taxes on land and buildings have a small adverse effect on economic growth, though are unpopular. These taxes do not affect the decisions of economic agents to supply labor, to produce or invest to the extent as some other taxes. Another advantage of property taxes is that the tax base is more stable making its revenue more predictable, partly due to less cyclical fluctuation in property values (Joumard and Kongsrud, 2003). Also, as real estate and land are highly visible and immobile these taxes are more difficult to evade, and the immovable nature of the tax base may be particularly appealing in the context of increasing tax competition. There is, however, a widespread popular and hence political resistance to their increased use stemming in part from their transparency and relatively limited scope for tax avoidance and evasion.

Recent reform proposals in CESEE entail significant revenue potential. Latvia introduced a residential property tax on buildings in 2010 to complement the existing land tax. Kosovo has recently introduced a more efficient and accurate cadastre. Serbia plans to replace the system of taxes based on property rights in tandem with a planned land privatization reform. In Croatia, a plan to introduce a new ad valorem property tax at a uniform tax rate of 1.5 percent, to replace existing ‘utility fees’ and the second home tax is being considered.

1/ This box was prepared by Ernesto Crivelli.2/ Due to data availability, the revenue figures relate to total revenue from property taxes, which may also include for some countries, recurrent taxes on net (of debt) wealth; taxes on estates, inheritances and gifts; financial and capital transaction taxes, or sales of immovable property.
  • By contrast, subsidies can distort the allocation of resources and therefore harm growth. Transfers such as unemployment benefits, especially when poorly designed, can reduce employment incentives and worsen labor market outcomes (Meyer, 2002; Abbring and others, 2005; OECD, 2006).

  • There are no clear theoretical priors for spending on goods and services—that is, public consumption. Public consumption is comprised of basic administrative services that economies need to operate efficiently, as well as education and healthcare spending. Excessive levels of public consumption can be inefficient and growth-damaging, however.

Empirics

To arrive at a quantifiable framework, empirical analysis complements the findings identified by theory. The results are based on panel regressions that relate real per-capita GDP growth to a country’s cyclically adjusted revenue and expenditure structure, following the approach introduced by Kneller et al. (1999)—see Annex VII for details.9 Regressions are performed across broad expenditure and revenue categories as reported in the World Economic Outlook (WEO) database. This approach yields some broad insights, but it also has limitations:

  • Cyclical adjustment of fiscal data is critical to prevent reverse causality from growth to revenue and expenditure categories. Data for all budget categories are adjusted using a methodology proposed by Bornhorst et al. (2011). The methodology allows for robustness checks by varying the elasticities of budget categories to the business cycle; as another check, regressions are estimated with GMM and instrumental variable techniques. This said, there can still be feedback if adjustment is imperfect or in the presence of within-year fiscal policy reactions to developments in growth.

  • The regression’s point estimates capture average patterns across expenditure and revenue categories. Especially on the spending side, this abstracts from composition within these categories: for example the share of public consumption spent on productive uses such as education or health, or the composition of the capital budget—although these issues are likely relevant for growth. More detailed expenditure categorizations, and/or a breakdown of expenditures by functional categories, would be desirable but are not available consistently across countries. On the revenue side, low yields from certain taxes can reflect low tax rates, large tax exemptions, or poor revenue administration—factors that have arguably different growth implications, but cannot be distinguished here.

  • Further, to keep the empirical model tractable it is linearized. Hence it abstracts from issues like returns to scale (for example, the possibility that public investment may become gradually less growth effective with larger amounts of investment).

With these limitations in mind, the results point in the following directions:

  • Revenues. Corporate income taxes and social security contributions correlate negatively with growth in CESEE, as suggested by theory. By contrast, neither consumption nor property taxes correlate significantly with growth. Interestingly, personal income tax is also not associated with a significant negative growth effect, which is in line with previous findings (Lee and Gordon, 2005; Federe and Dahlby, 2012). A growth-oriented revenue reform in CESEE economies would therefore shift the revenue base away from corporate income tax and social security contributions, and toward consumption taxes, property taxes, and personal income tax.10

  • Expenditures. On the spending side, transfers and public consumption in CESEE are significantly negatively correlated with growth (Annex Table VII. 1). The point estimate for public employment is also (slightly) negative but insignificant. By contrast, public investment is positively associated with growth.11 A growth-oriented spending reform in CESEE would therefore shift spending away from public consumption and transfers, and toward investment.

Figure 2.4.
Figure 2.4.

Estimated Impact of Fiscal Policy on Long-Term Growth

(Percentage points of real per capita GDP growth, 95% confidence interval)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

These results for CESEE and Advanced Europe are closely aligned with findings in earlier literature (e.g., Afonso and Alegre, 2011; Acosta-Ormaechea and Yoo, 2012; Acosta-Ormaechea and Morozumi, 2013). That said, results for other regions differ, especially on the revenue side.12

How Does Emerging Europe Score?

With this, the elements are in place to compile an index capturing the growth friendliness of CESEE’s budgets. The index multiplies the growth coefficients from above (Annex Table VII.1 and 2) with the deviations of the actual from the predicted budget structure (Annex Table VI. 1), then sums all revenue/expenditure categories.

Importantly, the index is relative: i.e., a positive value indicates that a country’s budget structure is more long-term growth friendly than that of its peers (that is, countries with identical structural characteristics), and vice versa. Further, and in line with the standard treatment in the literature, revenue and expenditure structures are analyzed separately. As these structures are not necessarily independent of one another—for example, higher social security contributions typically go hand in hand with higher transfers—the results for expenditures and revenues are not added up, in order to avoid double counting. The analysis is done for 2008—i.e., at the onset of the global financial crisis—and for 2014, which is the latest information available.

The results show that CESEE economies entered the global financial crisis with relatively growth unfriendly budget structures (Figure 2.5).

  • On the expenditure side, CESEE’s high transfers—a large portion of which redistribute from the young to the old—and, to a lesser extent, public consumption rendered the spending structure growth unfriendly. By contrast, public investment contributed positively to growth, being higher as a share of GDP than CESEE’s structural characteristics would suggest. Overall, in 2008 CESEE’s spending structure was less growth friendly than that of Advanced Europe.

  • The aggregate hides important differences between sub-regions, however. CIS countries, Central Europe, and Southeastern Europe had especially growth unfriendly spending structures. By contrast, the Baltics’ spending structure was broadly in line with peers, and Turkey’s spending structure was broadly favorable for growth, as transfers and public consumption were lower and public investment was higher than among peers.

  • CESEE scored equally poorly on the revenue side. High social security contributions were the main factor, for all sub-regions except Turkey.

Figure 2.5.
Figure 2.5.

Growth Friendliness of Budget Structures, 2008 and 2014

(Index)

Sources: IMF World Economic Outlook database; and IMF staff calculations

That said, in several aspects CESEE’s budget structures improved between 2008 and 2014.

  • On the spending side, for the CESEE region as a whole, cuts in transfers and in public investment broadly offset one another in terms of the growth orientation of spending. But the aggregate patterns masks large differences between subgroups: Central Europe, the Baltics and the CIS countries significantly improved the growth orientation of expenditures between 2008 and 2014, while structures in Southeastern Europe and Turkey deteriorated.

  • On the revenue side, corporate income tax receipts fell and are now less in CESEE than among peers, reflecting not only corporate tax rate reductions but also changes in tax base structures that are likely not related to policies (see below). This loss was mostly compensated by growth-neutral forms of taxations, in particular VAT.

How was the improvement in budget structures possible during a period when many countries went through sizable fiscal consolidation? What policies and structural developments underpinned changes in the spending and revenue structures? Is there a link between the quality and size of fiscal consolidation? The second part of this chapter looks at the evidence in more detail, complementing the quantitative findings with a qualitative analysis of fiscal developments in CESEE economies.

B. Budgetary Adjustment in the Wake of the Global Financial Crisis

The global financial crisis and its aftermath had a profound impact on CESEE countries’ budget structures. Yields from corporate income tax fell as a result of both tax cuts and structural shifts in the tax base. Governments compensated mostly by raising consumption taxes. On the expenditure side, consolidation affected primarily the public sector wage bill, transfers, and capital spending. This said, countries with access to EU structural funds often avoided large cuts in public investment. Overall, changes on the revenue side went generally into a growth friendly direction, while on the expenditure side outcomes differ widely between countries and sub-regions.

Fiscal Adjustment in CESEE, 2008–14

In the wake of the global financial crisis of 2008-09, many CESEE countries went through sizable fiscal adjustment (Figure 2.6). As global financial conditions tightened—even cutting some countries off external financing for a period—funding large deficits became more difficult. Further, the end to credit-fueled, domestic demand driven growth triggered a re-assessment of growth prospects, implying that many countries needed a tighter long-term fiscal stance than previously thought.

Figure 2.6.
Figure 2.6.

Fiscal Adjustment, 2008–14

(Change in structural primary balance, percent of potential GDP)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

Structural fiscal adjustment varied across sub-regions. The Baltic countries adjusted the most, followed by Southeastern Europe—with a wide variety of outcomes—and Central Europe. In Romania, Lithuania, Estonia and Bosnia and Herzegovina, structural fiscal adjustment exceeded 5 percentage points of GDP. In Latvia and Hungary, adjustment exceeded 5 percentage points of potential GDP for 2008-12, but some of this was reversed in 2013/14. Also in Croatia, the Czech Republic, and Ukraine structural fiscal adjustment was more than 3 percent. In all countries with very large adjustments, the effort was heavily frontloaded, often—but not always—in the context of IMF-supported programs (Romania, Bosnia and Herzegovina, Latvia, Hungary, Ukraine). Annex VIII contains a detailed description of country experiences with large adjustments.

Structural adjustment was, for the most part, expenditure-led.

  • The structural primary balance improved in 14 out of the 17 CESEE economies covered by this analysis, and in 9 of these, the structural reduction in spending was larger than the structural increase in revenues. For all very large adjusters identified above—Romania, Lithuania, Estonia, Bosnia and Herzegovina—consolidation was clearly expenditure-led, with structural spending cuts of 5 percent of GDP or more.

  • The largest structural revenue increases—about 4 percent of GDP—occurred in Turkey and the Slovak Republic. In both cases, however, higher revenues financed in large part higher spending (of about 2½ of GDP) instead of contributing to consolidation. Among the larger (overall) adjusters, consolidation was revenue-led only in Hungary and Latvia. The total for 2008-14 masks shifts over time, however, as in both countries fiscal adjustment started mostly on the expenditure side in 2008-10, before shifting to revenues in later years.

How Did Budget Structures Change?

Revenues

The global financial crisis and its aftermath had a profound impact on CESEE’s public revenue structures (Figure 2.7). On the revenue side, the yield from direct taxes—on personal and, especially, corporate income—fell, for all sub-regions except Turkey. In the CIS and CEE countries, the loss in CIT receipts often reflected cuts in tax rates—see Box 2.4 for a survey. However, in the Baltic and SEE countries, the (structurally adjusted) yield from CIT fell without a corresponding cut in tax rates. This points to structural shifts in these countries’ tax bases—notably the sustained decline in the construction sector that occurred in most CESEE countries in the wake of the global financial crisis, and structural declines in the profitability of financial corporations.13

Figure 2.7.
Figure 2.7.

Changes in Budget Structures, 2008–14

(Percent of potential GDP)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

Notwithstanding the fall in income tax yields, overall revenue increased (adjusted for the cycle), owing to two main factors:

  • Higher consumption taxes. VAT reform—a relatively growth friendly form of tax increases. Increases in standard VAT rates and, in some cases, also in reduced rates were a part of most countries’ fiscal consolidation packages. Romania, Hungary and the Baltic countries had especially large increases in VAT standard rates.

  • Higher non-tax revenues, including grants. Most EU member states increased the absorption of EU structural and cohesion funds, yielding on average revenue increases of 0.7 percent of GDP (and of more than 1½ percent of potential GDP in Bulgaria and Slovenia). Some countries in Central Europe and the Baltics also increased fees and other non-tax charges. A prominent example is Hungary, where sector-specific levies on banks, retail firms, and utility companies increased revenues by more than 2 percentage points of GDP.

Expenditures

Turning to expenditures, CESEE economies cut (in the aggregate) spending by 2 percent of potential GDP. At more than 4 percent of potential GDP, spending cuts were largest in the Baltic economies, followed by South-Eastern and Central Europe. In the CIS economies, spending levels remained (on average) unchanged. Turkey expanded spending, in line with the increase in revenues.

There are large cross-country differences in the structure of expenditure consolidation.

  • Capital spending. Most CESEE countries that tightened the fiscal stance in 2008-14 also cut public investment. However, investment cuts in non-EU member states exceeded those in EU member states on average by a full percentage point of potential GDP (1.4 percent vs. 0.4 percent). As EU structural funds finance mostly capital projects, this suggests that their availability to EU members helped mitigate pressures on public investment, with Hungary, Lithuania and Slovenia managing to even increase capital spending, despite fiscal consolidation.14 At the other end of the spectrum, Ukraine, Croatia, Romania and Serbia cut investment by 2½ percentage points of potential GDP or more, often motivating these cuts with insufficient prioritization and therefore inefficiency of public investment.

  • Current spending. The spending category with the largest consolidation was the public sector wage bill. Cuts averaged 1 percent of potential GDP across CESEE, exceeding 2 percent of potential GDP in Latvia, Romania, Lithuania, and Hungary. These reductions were achieved through a mix of public sector wage cuts (up to 25 percent in Romania), including through the elimination of extra payments such as 13th month salaries (Hungary), and reductions in public employment.

  • Further, several countries consolidated transfers, with cuts exceeding 2 percentage points of potential GDP in Hungary, Bosnia and Herzegovina, and Lithuania. There is no coherent cross-country pattern on the transfer categories most affected; examples include public pensions—including by curtailing pensions for privileged groups—maternity benefits, and, in the case of Bosnia, transfers to war veterans. Public consumption was typically only a minor consolidation item, but exceeded one percentage point of potential GDP in Lithuania, Slovenia, Romania and the Czech Republic.16

Tax Rates1/

Revenue reforms have been a key component in many countries’ fiscal consolidation efforts. A study of changes in tax rates allows for analyzing policy changes while abstracting from underlying structural or cyclical (and incompletely corrected) changes in the economy.

  • Most CESEE countries have raised VAT rates since 2008. In the Baltic and CEE countries, the VAT rate increased on average by close to 3 percentage points, although in SEE and CIS countries the increase has been about 1½ percentage points. This compares to an average VAT rate increase of 2 percentage points in Advanced Europe. In terms of levels, VAT rates in Baltic and CEE countries tend to be slightly higher than in Advanced Europe (21.9 percent on average vs. 21.1 percent, while in SEE and CIS countries they are lower at 19.8 percent.

  • Despite fiscal consolidation efforts, tax rates on corporate profits (CIT) have fallen in several countries, notably in CIS and CEE countries. CIT rates in CESEE are low compared to advanced Europe (15.9 percent vs. 25 percent in 2014).

  • Labor taxes remain high. At 39.2 percent, the average labor tax wedge in CESEE (from personal income tax and social security contributions) exceeds that in advanced Europe (38.2 percent).15 Since 2008, the tax wedge has on average increased by less than ½ of a percentage point. This is significantly less than the increase of more than 2 percentage points in advanced Europe.

1/ This box was prepared by Haonan Qu.

How Growth Friendly Were Budget Changes?

Evaluating these changes with the help of the empirical model described above suggests that CESEE’s shift from income taxes to indirect taxes and non-tax revenues improved the revenue structure, as the tax burden shifted from taxes considered harmful to growth to broadly growth neutral forms of taxation (Figure 2.8). This pattern shows up in all sub-regions except Turkey (where large increases in social security contributions worsened the revenue structure). On a country-by-country basis, the model-based analysis suggests that 10 of 17 CESEE economies improved their revenue structures over 2008–14.

Figure 2.8.
Figure 2.8.

Growth Friendliness of Changes in Budget Structures, 2008–14

(Index)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

As for expenditures, the divergent patterns of consolidation translate into different estimated long-term growth effects. As Central European and Baltic countries reduced primarily current expenditures while preserving capital spending, their spending structures typically improved. By contrast, in Southeastern Europe and the CIS countries, public investment fell significantly, causing the expenditure structure to become less growth supportive. Overall, 6 of 17 countries improved their spending structures.

Quality and Size of Fiscal Consolidation

Does the size of fiscal adjustment affect its quality? And is expenditure-led or revenue-led consolidation more growth friendly? CESEE’s experience provides some insights. Figure 2.9 displays expenditure-side and revenue-side consolidation separately, and groups countries by whether expenditure/revenue-side adjustments were large or more modest. Further, Figure 2.9 shows which spending/revenue categories adjusted, and groups these into growth-positive (green), growth-neutral (blue) or growth-negative (red), in line with the analysis above.

  • Growth friendly adjustment on the revenue side requires shifts in revenues away from categories like corporate income tax and social security contributions to consumption tax personal income tax, or property tax. In CESEE, such shifts occurred only when revenue-side adjustment was at most 2½ percentage points of potential GDP. Countries that increased revenues by even more resorted to raising social security contributions, which are associated with a detrimental impact on the budgetary structure.

  • On the expenditure side, cuts in public investment render adjustment growth unfriendly. In CESEE, large consolidation did not come with disproportionate cuts in investment. Instead, large adjusters realized savings primarily by curtailing public consumption and transfers—steps that ultimately enhanced the growth friendliness of their budgets, all else being equal.

Figure 2.9.
Figure 2.9.

Size vs. Composition of Adjustment, 2008–14

(Percent of potential GDP)

Sources: IMF World Economic Outlook database; and IMF staff calculations.

While caution is warranted generalizing CESEE’s experiences, the results suggest that the scope for growth friendly revenue-based consolidation is limited. Large adjustment should therefore contain a significant portion of spending-side measures, in particular in countries where overall spending levels are high.

Key Takeaways from the Analysis

Despite severe fiscal consolidation pressures in the wake of the global financial crisis, many CESEE countries managed to avoid deteriorations in their budgetary structures.

  • On the revenue side, most countries were faced with large structural losses on corporate income tax, but managed to over-compensate for this by increasing revenues from less growth-harmful forms of taxation, in particular value added taxes.

  • On the spending side, the Baltic and Central European countries typically managed to resist large cuts in public investment, reflecting in part the availability of EU structural funds. Large fiscal savings came instead from reforming entitlement programs and cutting public consumption. Consolidation in SEE and CIS countries, by contrast, resorted more to cuts in capital spending.

  • In Turkey, both government spending and revenue grew in cyclically adjusted terms, yielding some deterioration in the budget structure. However, in contrast to much of the rest of CESEE, Turkey’s starting position was strong, and its budget, in terms of its broad orientation, remains relatively growth friendly compared to peers.

Looking ahead, sizeable fiscal policy challenges remain in CESEE—and this chapter’s analysis contains several recommendations how to address these.

  • Fiscal consolidation has not yet run its course, especially in SEE.

    For countries with sizable remaining fiscal adjustment needs, the focus should be on reducing unproductive transfer and subsidies, and on further reforming entitlement programs, including public pension systems that absorb a large share of resources in CESEE. Restructuring the public sector may also be called for where the public sector wage bill is high, either because of excessive employment or disproportionately high public sector wages. Countries with access to EU structural and cohesion funds should seek to leverage these so as to avoid cuts in public investment.

    On the revenue side, policy makers should focus on achieving a sizable part of adjustment through indirect taxes—notably VAT, especially when existing VAT rates are modest compared with those of peers—and give consideration to the introduction or strengthening of carbon and property taxes. On income taxes, broadening tax bases by eliminating tax expenditures while reducing marginal rates is a priority.

  • For countries that do not have urgent fiscal consolidation needs, fiscal reform is still called for to enhance the quality and growth-friendliness of their budgets.

    • Where corporate income taxes are high, governments should seek to bring rates more in line with peers. If distributional aspects are a concern, a relatively growth friendly option is to eliminate instead exemptions from personal income tax.

    • While CESEE’s high transfers arguably reflect a conscious policy choice in favor of equity, financing a larger portion from general taxation, particularly indirect taxes, instead of social security contributions would enhance the growth friendliness of the welfare state. A careful design is needed for social security contributions and their interaction with the withdrawal of social transfers upon taking up work, to avoid employment and poverty traps.

    • Growth friendly fiscal reform should seek to enhance the amount and efficiency of health and capital spending, while limiting unproductive transfers and subsidies.

  • Finally, it is worth recalling that there are many issues critical for the quality of fiscal policy that go beyond this chapter, but are covered in detail in other IMF publications (including IMF, 2014c, 2015a,c). These include: (i) enhancing spending efficiency, especially on health and public infrastructure; (ii) improving the design of fiscal policies, notably the careful calibration of transfers to limit any negative impact on labor supply; (iii) improving the composition of spending within expenditure categories, such as protecting spending on health and education within public consumption; and (iv) strengthening budget institutions to deliver more growth-friendly fiscal consolidation.

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