This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.

Abstract

This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.

III. Lessons from Large Fiscal Adjustments1

This chapter examines the international experience of large fiscal adjustments to identify the components of successful fiscal consolidations. The chapter is largely atheoretical in that it focuses on examining associations rather than attempting to establish causality. Nonetheless, some clear patterns emerge from the evidence: frontloaded and expenditure-based adjustments, particularly those focused on reducing transfers and public wages, are associated with longer-lasting budgetary improvements. In contrast, very large fiscal efforts do not necessarily guarantee success if these come too late. The evidence on the usefulness of fiscal rules in supporting fiscal consolidation is generally positive, though rules appear to be neither a necessary nor a sufficient condition for success.

A. Introduction

1. The large deterioration of fiscal positions as a result of the global financial crisis will require a major and sustained fiscal adjustment in most advanced economies. Under current growth projections, the average debt ratio in advanced economies is estimated to increase to about 110 percent of GDP by end-2014, from 75 percent of GDP at end-2007. This would require an average improvement in the structural primary balance of 8¾ percentage points of GDP during 2011–20 in order to achieve a debt ratio target of 60 percent by 2030.2

2. The scale of the fiscal challenge is especially large in the case of the UK. The fiscal deficit is expected to remain close to 10 percent of GDP in 2010. The UK will spend more on debt service relative to revenue this year than any other AAA-rated economy, except the US. And gross debt is expected to increase by about 32 percentage points of GDP between 2007 and 2010, the second largest increase among advanced economies (Table 1).

Table 1.

Fiscal and Debt Fundamentals in the G-7

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Source: IMF WEO estimates, October 2010.

3. This chapter draws on the international experience of large fiscal adjustments to identify the components of successful fiscal consolidations. A successful consolidation is one that brings about a sustainable reduction in debt and is not accompanied by large output contractions or high unemployment. More than twenty advanced economies have undergone large adjustments (defined as reductions in the structural primary balance of more than 5 percentage points of GDP) since 1975 (Table 2).3 The analysis of the composition, speed, intensity, and determinants of these adjustments may hold lessons for the UK and other advanced economies in the challenging period ahead. The role that fiscal rules played during these adjustment episodes is also assessed.

Table 2.

Country Experiences with Large Fiscal Adjustments

article image
Sources: IMF, World Economic Outlook, October 2009 and IMF staff calculations.

Cumulative change in cyclically-adjusted primary balance in percent of GDP. In a given consolidation episode, the cyclically-adjusted primary balance should not be reversed by more than 1 percentage point from one year to the next.

An expenditure-driven adjustment is defined as one where at least two-thirds of the adjustment is made by expenditure cuts. A frontloaded adjustment is one where at least 40 percent of the adjustment is made in the first two years. A high-intensity adjustment is one where the average annual consolidation is at least 1.5 percent of GDP.

4. Although the chapter is largely atheoretical, some clear patterns emerge from the evidence. The emphasis is on presenting the evidence rather than testing hypotheses (although several possible explanations are suggested along the way). In other words, the chapter looks at patterns rather than seeking to establish causality. Still, some of the evidence presented in the chapter is quite striking and could be of value to policymakers. The findings of the chapter can be summarized as follows:

  • Expenditure-based consolidations, particularly those focused on reducing transfers and public wages, are generally associated with longer-lasting budgetary improvements than tax increases.

  • Addressing the fiscal problem in a timely fashion, by frontloading the adjustment, is also associated with more sustainable debt reductions.

  • In contrast, very large fiscal efforts do not necessarily guarantee success if these come too late or if borrowing costs do not fall because the government’s fiscal credibility is not maintained. The reduction in the risk premium and improvement in the interest rate-growth differential, which accompanied expenditure-based and frontloaded fiscal adjustments, were crucial to their success.

  • The evidence on the usefulness of fiscal rules in supporting fiscal consolidation is positive but not conclusive.

5. The chapter is organized in five sections. The next three sections review the evidence regarding three key dimensions of fiscal adjustments: composition, degree of frontloading, and intensity. At the end of each section, there is a discussion about what determines the countries’ choice along each dimension. The fourth section presents evidence about the effectiveness of fiscal rules in delivering sustainable debt reductions. The final section concludes and draws implications for the UK.

B. Does the Composition of the Fiscal Adjustment Matter?

6. Expenditure-driven adjustments have proved to be more successful in achieving the following objectives (Figure 1):

  • Reducing debt. The average debt ratio fell sharply in the 5–8 years following expenditure-driven consolidations and remained at a lower level, whereas debt continued to rise following tax-driven adjustments. An expenditure-driven adjustment is defined as one in which at least two-thirds of the adjustment is made by expenditure cuts. About 40 percent of the events under study fall in this category (Table 2).

  • Improving growth performance. Adjustments based on spending cuts have been followed by higher growth (non-Keynesian features of fiscal consolidations are discussed in Box 1). In contrast, the impact on growth following tax-driven adjustments was slightly negative.

  • Reducing unemployment. Like GDP growth, the mean unemployment rate for the group of economies that engaged in spending cuts fell considerably over the 5-8 years that followed, while it increased in countries that relied more heavily on tax increases.

  • Narrowing spreads and reducing borrowing costs. Sovereign bond spreads fell under both types of adjustments as investors’ confidence on the sustainability of public finances improved. However, they fell much faster following expenditure-driven adjustments.

  • Improving external position. Starting from similar levels, the current account balance followed opposite trends under both types of adjustments. The large improvement following expenditure-driven adjustments could be explained by expenditure switching effects. Assuming public spending concentrates mostly on the non-tradable sector, cuts in public spending change the composition of aggregate spending in the economy in favor of the tradable sector. Another possible explanation could be reductions in unit labor costs associated with public sector wage growth moderation, which help boost competitiveness of the export sector. Indeed, unit labor costs indicators improved following expenditure-based consolidations, while they worsened following tax-based adjustments.

  • Accelerating FDI flows. Starting two years after the beginning of the adjustment, this likely reflects the higher credibility and growth prospects of expenditure-based adjustments as well as reductions in the risk premia that crowed in private investment.

Figure 1.
Figure 1.

Composition of Fiscal Adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources:WEO and staff estimates.1/Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

Growth Effects of Fiscal Adjustments: The Theory

Keynesian theory

A fiscal contraction has a temporary contractionary effect through and aggregate demand channel. Such reduction will occur either directly, through the decrease in public consumption and investment, or indirectly, when households reduce their consumption as a consequence of a lower disposable income, brought about by the increase of taxes or by the decrease of public transfers. A standard multiplier effect implies that spending cuts are more recessionary than tax increases.

Expansionary fiscal contractions (non-Keynesian effects)

Wealth effects on consumption

A cut in government spending, if perceived as long lasting, implies a permanent reduction in the future tax burden of consumers, generating a positive wealth effect, leading to an increase in private consumption (Ricardian behavior). See Feldstein (1982), Blanchard (1990), Bertola and Drazen (1993), Alesina and Perotti (1997).

Credibility effects

By reducing their budget deficits, governments signal to markets their commitment to sound finances. If this signal is taken as credible, risk premia on interest rates will fall, crowding in private investment and raising agents’ permanent income. See McDermott and Wescott (1996), Giavazzi et al. (2005).

Labor market channel

Fiscal consolidations obtained through expenditure cuts, in particular of the government wage bill, will reduce wage pressures and increase short-term investment. In this case, the possibility for fiscal consolidations to be expansionary crucially depends on the composition of the adjustment. See Alesina and Perotti (1997), Alesina et al. (2002), Ardagna (2004).

7. The divergent performance under expenditure-based and tax-based adjustments cannot be accounted for by differences in initial conditions or the scale of the fiscal problem. The size of the required fiscal effort was similar in both group of countries, as reflected by the overall budget deficit and the structural primary deficit in the pre-adjustment year (Figure 2). Nevertheless, five years after the start of the adjustment, the structural primary balance had improved by 3 percentage points of GDP more in countries that cut spending more aggressively.

Figure 2.
Figure 2.

Fiscal deficits and the composition of fiscal adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources:WEO and staff estimates.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

8. There is no evidence that the better external and growth performance following expenditure-driven adjustments was the result of exchange rate weakness. On the contrary, the NEER appreciated on average for this group of countries, whereas it depreciated sharply in countries that relied primarily on tax increases (Figure 3). However, the ULC-based REER did depreciate following expenditure-based adjustments as a result of public wage moderation, thus improving competitiveness of the export sector. To be sure, the evolution of the NEER and REER is the result of multiple factors and it is not the objective of this chapter to establish causality between these and the type of fiscal adjustment.

Figure 3.
Figure 3.

NEER, inflation, interest rates, and the composition of fiscal adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

9. Economies that relied primarily on spending cuts did not inflate their debt away, but grew out of their debt. Some argue that higher inflation is a reasonable price to pay to reduce the real value of debt. But higher inflation played no role in reducing debt in expenditure-driven adjustments. Indeed, inflation was halved in the five years after the start of the expenditure-driven budgetary adjustment. This facilitated a more accommodative monetary policy that provided an offsetting boost to demand. Improved growth performance and lower risk premia following expenditure-based adjustments brought about favorable interest rate-growth differentials that significantly improved debt dynamics. In contrast, the interest rate-growth differential worsened following tax-based adjustments (Figure 3). This highlights that fiscal-monetary policy interaction during episodes of fiscal consolidation is crucial.

10. To summarize, the composition of the fiscal adjustment matters. Why? Credibility effects are likely a driving force. Public spending cuts, particularly in wages and entitlements that are politically sensitive, may signal that the government is fully determined to tackle the fiscal problem. Other explanatory factors could include: (i) wealth effects resulting from the perceived more permanent nature of expenditure-based adjustments, and (ii) increased competitiveness associated with public sector wage moderation and expenditure switching from the non-tradable to the tradable sectors (see Box 1 for a review of the theory supporting non-Keynesian features of fiscal adjustments).

What determines the composition of the fiscal adjustment the countries choose?

11. The composition of the fiscal adjustment appears to be chiefly determined by space available to implement revenue or expenditure measures. In countries where the revenue to GDP ratio was already high, the scope for raising taxes was constrained and expenditures were cut more aggressively. There is indeed a positive relationship between the share of adjustment made by spending cuts and the initial (pre-adjustment year) level of revenues to GDP (Figure 4). Similarly, there is a positive correlation between the initial level of government expenditures to GDP and the share of the adjustment coming from spending cuts.

Figure 4.
Figure 4.

Determinants of the Composition of Fiscal Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.

12. Market discipline—threat of higher interest rates—does not appear to have influenced the composition of the fiscal adjustment. Bond spreads at the outset of the adjustment were in fact somewhat lower in economies that cut expenditures more aggressively. However, as discussed above, expenditure-driven adjustments were seen as more credible and spreads fell faster subsequently (by 200 basis points after 5 years).

13. The magnitude of the pre-adjustment fiscal deficit was not a determinant of the composition of the fiscal adjustment. The required fiscal effort in countries that relied on expenditure cuts was not larger than elsewhere. There is indeed no significant relationship between the level of the structural primary deficit in the pre-adjustment year and the share of adjustment made by expenditure cuts. However, past episodes suggest that a higher starting level of debt and a higher starting unemployment rate seem to be associated with expenditure-based adjustments. Whether this association is causal or spurious is hard to assess, but it is possible that large debts and unemployment raise public awareness of the fiscal problem, helping to overcome resistance to consolidate and to implement unpopular spending cuts.

14. A simple regression exercise confirms these findings. The charts in Figure 4 could prompt the objection that they mask important relationships because they only consider one dimension at a time. It could be illuminating to control for all the possible determinants of the composition of fiscal adjustments at the same time in a simple regression framework. To this end, the share of the adjustment made by expenditure cuts is regressed on the initial (pre-adjustment) size of the public sector, measured by the ratio of revenues or expenditures to GDP, along with the initial levels of debt, unemployment, spreads, and structural primary deficit. The regression results suggest that only the size of the public sector has explanatory power. More specifically, a one percentage point increase in the revenue (expenditure) to GDP ratio is associated with a 2 percentage point increase in the share of adjustment coming from spending cuts. None of the other variables in the regression are statistically significant (Table 3).

Table 3.

Determinants of Expenditure-based Adjustments 1/

article image
Source: IMF staff calculations.

Regressions are OLS; ** denotes statistically significant at 5 percent level.

Where did the axe fall in successful fiscal adjustments?

15. Successful adjustments concentrated on cuts in transfers, welfare spending, and public wages (Figures 5 and 6). The composition of spending cuts was strikingly different in successful and unsuccessful adjustments. 4 In successful cases, over 80 percent of the adjustment was on social benefits, subsidies, and government wages. Public investment was also affected, but cuts accounted for less than one-sixth of the total. Other current spending, including purchases of goods and services, also fell, albeit marginally. In contrast, public investment was the hardest hit spending component in unsuccessful adjustments. In these cases, wages were little changed, and social benefits and subsidies increased sharply, fully offsetting the cuts in all other categories. As a result, five years after the start of the adjustment total government expenditure to GDP had increased slightly.

Figure 5.
Figure 5.

Successful Fiscal Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: OECD and staff estimates.1/Time t refers to the first year of the consolidation episode.
Figure 6.
Figure 6.

Components of Government Spending 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: OECD.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

16. The quality of the expenditure-based adjustment matters. Spending cuts that focus on wages and transfers may be viewed as more credible as they tackle politically sensitive components. These measures also place downward pressure on private sector wages, improving unit labor costs and external competitiveness indicators. In contrast, cuts in public investment and non-wage goods and services can have direct negative effects on investment and growth as well as unfavorable credibility effects, as they may be viewed as simply postponing the required adjustment.

C. Does It Matter Whether the Fiscal Adjustment is Frontloaded?

17. A critical question facing policymakers in advanced economies is how frontloaded the required adjustment should be. Is it preferable to inflict a larger pain at the beginning or would a more gradual adjustment deliver better results? Again, historical episodes can shed some light on this issue. A frontloaded adjustment is defined as one in which at least 40 percent of the required effort takes place in the first 2 years. A frontloaded adjustment is not necessarily a larger or shorter one, but more resolute and aggressive one at the beginning (Box 2). About a third of the historical events under study can be defined as such (Table 2).

18. Frontloaded adjustments appear to deliver better results (Figure 7):

  • They coincide with better growth outcomes, lead to faster and sustainable debt reductions, and are accompanied by a sharp reduction in bond spreads, interest rate-growth differentials, and unemployment. In contrast, more gradual (or delayed) adjustments coincide with worse growth outcomes and non-declining debt ratios.

  • The better debt and growth performance does not appear to stem from differences in the size of the adjustment needed, higher inflation, or relative weakness in the currency.

Figure 7.
Figure 7.

Degree of Frontloading of Fiscal Adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

19. This suggests that decisive fiscal action can help in delivering a successful adjustment. Governments are well advised to implement a non-trivial first installment of adjustment measures. Why? Again, credibility matters and promises of future action will not be enough. The uncertainty about the future course of fiscal policy associated with more gradual or delayed fiscal adjustments can deteriorate market sentiment and be damaging for growth. As a result, more gradual adjustments may fail to stabilize debt ratios or reduce spreads. In contrast, frontloaded adjustments tend to coincide with better growth outcomes, perhaps because they signal a decisive, credible, and permanent reversal in the stance of fiscal policy. Furthermore, the larger reduction in the risk premium and interest rates accompanying these adjustments can provide an additional boost to demand. In turn, more favorable interest rate-growth differentials lead to faster and more sustainable debt reductions.

What determines the degree of frontloading of the fiscal adjustment the countries choose?

20. The initial level of debt appears to be the main determinant of the speed of fiscal adjustments. The higher the initial level of debt, the higher is the share of the adjustment in the first two years. Interestingly, other factors—including the initial deficit, level of spreads, unemployment, and public sector size—were less correlated with the choice to frontload adjustment (Figure 8). These results are also confirmed in a simple regression framework. However, this does not imply that only the debt level should be considered when designing adjustment, as past adjustments have not always been optimal and factors other than debt can affect the likelihood of fiscal crises. In the recent UK context, frontloading may also have been affected by sovereign turmoil in parts of Europe, an event not captured in the historical analysis.

Figure 8.
Figure 8.

Determinants of Frontloaded Fiscal Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.

D. Does More Pain Lead to Greater Gain?

21. A related question that policymakers face is whether the magnitude of the adjustment effort, defined as the size of the average annual adjustment—regardless of whether this is frontloaded or not—influences the likelihood of a long-lasting debt reduction. To address this question, the sample is split in two groups: countries that undertook average annual adjustments of at least 1½ percent of GDP per year in the cyclically-adjusted primary balance and those where the intensity (average consolidation per year) was smaller.5

22. Somewhat surprisingly, an increased intensity of adjustment is not strongly associated with more rapid debt reduction. On average, high-intensity adjustments (larger average consolidation per year) reduce debt initially, but this debt reduction is reversed after four years of the start of the adjustment. Similarly, while growth increases on average by the third year of such adjustments, it then falls, with a slightly negative net effect. Spreads also do not fall significantly. Eventually, high-intensity adjusters do not end up, on average, with lower debt levels than cases where the average annual effort was smaller (Figure 9).

Figure 9:
Figure 9:

Intensity of Fiscal Adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

23. It is not easy to explain this evidence. Some hypotheses that could explain the lack of success of high-intensity adjustments are discussed:

  • Worse initial conditions. The size of the fiscal problem, measured by the structural primary deficit in the pre-adjustment period, was more than twice as large in high-intensity adjusters (6 percent of GDP vs. 2.8 percent of GDP, Figure 10).

  • Insufficient frontloading of the adjustment. The effort made by high-intensity adjusters was smaller at the beginning than later on (Box 2). If the adjustment in the first few years was viewed as insufficient in relation to the total size of the problem, the credibility of the debt reduction strategy may have been called into question. This could explain why the consolidation was not accompanied by a reduction in the credit risk premium and why the interest rate growth differential worsened after two years of the beginning of the adjustment. Even the acceleration in the pace of consolidation that followed after wards (possibly “forced” by financial markets) did not reverse the deterioration in debt dynamics.

Figure 10.
Figure 10.

Fiscal Deficits and the Intensity of Fiscal Adjustments 1/

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.1/ Time t refers to the first year of the consolidation episode. Lines in the charts refer to means across groups.

24. Addressing the fiscal problem in a timely fashion may reduce the need for future fiscal tightening, in turn raising confidence. Establishing credibility at the beginning, by frontloading the adjustment, seems to be more important than a larger adjustment if this comes too late (Box 2). This could explain the different outcomes following high-intensity adjustments, compared to the frontloaded adjustments discussed in the previous section.

Frontloaded vs. High-Intensity Adjustments

An adjustment is defined as frontloaded if more than 40 percent of the total consolidation effort takes place in the first two years. A high-intensity adjustment is one where the improvement in the cyclically-adjusted primary balance (CAPB) is at least 1½ percent of GDP per year.

These two aspects of the fiscal adjustment are not related.

  • Frontloaded adjustments were not larger or higher-intensity than non-frontloaded ones. The overall size of the adjustment, measured by the total improvement in the CAPB, and the length of the consolidation episode were similar in both cases. Moreover, as the chart shows, the average consolidation effort per year (intensity) was also similar—about 1½ percent of GDP—in both frontloaded and non-frontloaded episodes. However, more than half of the total consolidation was made in the first two years in frontloaded adjustments, compared to less than one-third in the rest. The average annual consolidation in the first two years was 2 percent of GDP in frontloaded adjustments vs. 1.3 percent of GDP in the rest.

  • High-intensity adjustments were not more frontloaded than low-intensity ones. The share of the total consolidation made in the first two years was similar in both groups (38-39 percent). The total size of the adjustment, though, was much larger in high-intensity adjustments (10 percent of GDP vs. 7 percent of GDP).

uA03fig01

How do high-intensity and frontloaded adjustments compare? Although the absolute effort in the first two years was very similar in both cases (about 2 percent of GDP per year), it was much higher in relation to the total adjustment in frontloaded cases. This, along with differences in the size of the required effort, could explain why growth, debt, and interest rate performances differed significantly under both adjustments. It is the effort made at the beginning relative to the total required adjustment what seems to matter most.

What determines the intensity of the fiscal adjustment the countries choose?

25. There are three main factors that seem to influence the intensity of consolidation (Figure 11). A higher fiscal effort per year was positively associated with:

  • Higher initial spreads. While this does not seem to influence the composition or whether to frontload the adjustment, market discipline seems to lead to higher-intensity adjustments.

  • Higher initial deficits. The scale of the fiscal problem prompted governments to increase the annual consolidation effort.

  • Larger increases in the debt ratio. Interestingly, the initial level of debt played no role. In fact, high intensity adjustments started from slightly lower debt levels, but had experienced a sharper increase in the two years before the adjustment started.

A regression analysis that controls for all these, and other, factors jointly confirms that the initial level of spreads, the initial deficit, and the increase in debt are the most important explanatory variables.

Figure 11.
Figure 11.

Determinants of the Intensity of Fiscal Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.

E. Do Fiscal Rules Help?

26. The recent crisis forced many countries to modify, abandon, or suspend their national or supranational fiscal rules. The UK suspended its two fiscal rules (golden rule over the cycle and net debt limit of 40 percent of GDP) at the end of 2008. The government adopted a temporary “operating rule” at the 2008 Pre-Budget Report to allow sufficient flexibility in the operation of fiscal policy during the recession. This was later replaced by a Fiscal Responsibility Act in the 2009 Pre-Budget Report.

27. How helpful is a rule-based framework in achieving a successful (long-lasting) debt reduction and improving fiscal performance? Previous empirical evidence has been generally favorable about the role of certain fiscal rules, namely those with embedded expenditure or cyclically-adjusted balance targets. But there are many caveats accompanying these findings. The main one is that the positive association between fiscal rules and fiscal performance may reflect that governments committed to prudent fiscal management are more likely to institute a rule, rather than a reflection of the rule’s effectiveness.

28. This section draws on the international experience of large fiscal adjustments to shed some light about the usefulness of fiscal rules. About half of the countries that have undergone large fiscal adjustments over the last 35 years had fiscal rules in place or adopted a new rule during the adjustment period (Table 2). A comparison of performance during these episodes relative to countries without rules may provide some insights on this debate.

29. The evidence on the usefulness of fiscal rules in supporting fiscal consolidation is positive but not conclusive. Debt fell somewhat in the first five years of the adjustment period in countries with fiscal rules, while it kept increasing in those without rules. Fiscal rules were associated with a larger reduction in unemployment and, to a lesser extent, bond spreads. However, the deficit performance was significantly better after five years of consolidation in countries that did not use rules (3½ percentage point of GDP larger structural primary surplus). The overall growth performance was not better either in rule-based adjustments by the end of the same period (Figure 12, 13).

Figure 12.
Figure 12.

Rule-Based Fiscal Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.
Figure 13.
Figure 13.

Fiscal Deficits and Rule-Based Adjustments

Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A003

Sources: WEO and staff estimates.

30. Rule-based adjustments are more likely to rely on expenditure cuts, which could explain the somewhat better performance. About two-thirds of the adjustment was made through spending cuts in countries that adopted rules, compared to two-fifths elsewhere. There is no evidence that rules make countries frontload the adjustment or increase the average fiscal effort per year.

31. Fiscal rules are neither a necessary nor a sufficient condition for success, but well-designed rules could help improve fiscal performance in some cases. Fiscal rules are likely to enhance fiscal policy credibility and discipline, and anchor medium-term expectations regarding fiscal sustainability. But other institutional frameworks, such as strong public financial management mechanisms, appropriate procedural rules, and independent fiscal agencies that provide (among other outputs) unbiased fiscal forecasts could also be important in promoting fiscal discipline and may be needed to make fiscal rules effective. Such institutional differences, as well as variation in the quality of rules themselves, might help explain why rules are associated with better outcomes in some cases but not others.

F. Conclusions and Implications for the UK

32. Evidence in the sample studied suggests that expenditure-based and frontloaded adjustments were more successful in ensuring debt sustainability. They were also accompanied by improved macroeconomic performance. Credibility and wealth effects seem to be a driving force, but further research is necessary to establish causal effects. In contrast, very large annual deficit reductions do not necessarily guarantee success if these come too late or if borrowing costs do not fall because the government’s fiscal credibility is not maintained. Further, the presence of fiscal rules could help improve fiscal performance, but it is hard to disentangle the effect of the rule per se from the government’s commitment to prudent fiscal management. Finally, the design of actual fiscal adjustment would need to depend on country-specific circumstances.

33. The UK’s consolidation plan is broadly consistent with the key qualities of successful fiscal adjustments suggested by the evidence in this chapter. In particular:

  • The consolidation is frontloaded. The argument for decisive action in the UK is strong. The surge of debt as a result of the crisis is amongst the largest in advanced countries and so is the size of the structural deficit. A large adjustment at some point is therefore inevitable. If past international experience is of any guide, frontloading the fiscal effort—as the UK authorities have announced—could lead to longer and faster debt reduction, as credible and frontloaded fiscal consolidation plans appear to have more positive macroeconomic effects through greater certainty and confidence about the future, while reducing total fiscal costs.

  • The consolidation is mainly expenditure-based, but not exclusively so given the magnitude of the problem. The empirical evidence in this chapter, and in other academic studies, has emphasized that adjustments that rely primarily on spending cuts are more likely to achieve a sustainable reduction in debt. This, however, does not preclude tax increases, as the optimal combination of specific measures depends on country-specific circumstances and the source of fiscal imbalances. In the UK, the large rise in the expenditure-to-GDP ratio over the last decade supports the emphasis on expenditure reduction. However, revenue-enhancing measures must also be part of the solution given the magnitude of the needed effort to stabilize debt. On this front, the authorities have announced several tax increases, including a hike in the VAT rate from 17½ percent to 20 percent from January 2011, a hike in the capital gains tax from 18 percent to 28 percent, and small bank levy on selected wholesale liabilities.6 Other measures that could be considered include efforts to broaden the tax base and eliminate distortionary exemptions in the tax system. The evidence in this chapter suggests that consolidations that rely heavily on reductions in the public sector wage bill and transfers tend to be more successful. In contrast, very large cuts in investment spending are less helpful, although they are easier to attain in the near term than fiscal structural reforms. In addition, in past successful episodes, cuts in goods and services contributed little to the total adjustment. This would suggest that efficiency gains alone cannot be relied upon to deliver a large and successful consolidation.

34. Fiscal-monetary policy interaction during the fiscal consolidation period will be crucial. There are currently sizeable monetary offsets to the impending fiscal tightening, and the flexible exchange rate could provide additional support. Policy interest rates are close to zero and the Bank of England has completed a large quantitative easing program. These policies have helped induce a significant depreciation of sterling, and continued monetary stimulus will help limit the fallout from fiscal adjustment. The caveat is that interest rates cannot fall much further and that fiscal multipliers are likely to be larger when nominal interest rates are held constant near the zero bound. In this case, quantitative easing could be resumed in the event of heightened disinflationary pressure, and the exchange rate also remains as a key shock absorber.

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  • International Monetary Fund, 2010c, “From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies,” April 2010, (Washington: International Monetary Fund).

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  • McDermott, C. J. and R. F. Westcott, 1996, “An Empirical Analysis of Fiscal Adjustment,” IMF Staff Papers.

1

Prepared by Marta Ruiz-Arranz (EUR).

3

The methodology to identify large fiscal adjustment episodes was developed in IMF (2010b).

4

A successful adjustment is one where: (i) three years after the start of the adjustment, the cyclically-adjusted primary balance had improved by at least 3 percentage points of GDP, or (ii) five years after the start of the adjustment, the debt ratio had fallen by at least 5 percentage points of GDP. Alesina and Perotti (1997) use similar criteria to characterized successful fiscal adjustments. About 60 percent of the episodes under study are considered successful using this definition, including some cases defined as tax-based adjustments in section B.

5

The mean and the median annual consolidation across episodes in the sample are about 1½ percent of GDP.

6

International evidence suggests that broad-based consumption and property taxes are less harmful to growth than income taxes (IMF, 2010c).

United Kingdom: Selected Issues Paper
Author: International Monetary Fund