This Selected Issues paper discusses some options to strengthen Iran's fiscal framework, and highlights the need for a medium-term framework. Fiscal policy design in Iran faces numerous challenges. Some are current, such as managing volatile oil revenue while addressing development needs. Other challenges are related to demographic pressures from new entrants to the labor market, as the country needs to prepare from aging pressures in the decades to come. With medium-term planning, macroeconomic stability, and adequate spending, fiscal policy could play a critical role in fostering growth. Ultimately, addressing these issues would help Iran achieve its objective of becoming one of the fastest-growing emerging economies.

Abstract

This Selected Issues paper discusses some options to strengthen Iran's fiscal framework, and highlights the need for a medium-term framework. Fiscal policy design in Iran faces numerous challenges. Some are current, such as managing volatile oil revenue while addressing development needs. Other challenges are related to demographic pressures from new entrants to the labor market, as the country needs to prepare from aging pressures in the decades to come. With medium-term planning, macroeconomic stability, and adequate spending, fiscal policy could play a critical role in fostering growth. Ultimately, addressing these issues would help Iran achieve its objective of becoming one of the fastest-growing emerging economies.

A Medium-Term Perspective to Fiscal Policy Design1

Fiscal policy design in Iran faces numerous challenges. Some are current, such as managing volatile oil revenue while addressing development needs. Other challenges are related to demographic pressures from new entrants to the labor market, as the country needs to prepare from aging pressures in the decades to come. This note provides some options to strengthen Iran’s fiscal framework, highlighting the need for a medium-term framework, anchored on key variables such as the non-oil fiscal deficit. Looking forward, fiscal rules could be considered, once a medium-term fiscal framework is in place.

A. Current Challenges: Limited Fiscal Space for Development Spending

Iran faces a number of fiscal policy challenges, from oil revenue shocks and fuel subsidies, to budget fragmentation and rigidities, all of which have contributed to procyclical policies and low growth performance. With medium-term planning, macroeconomic stability, and adequate spending, fiscal policy could play a critical role in fostering growth. Ultimately, addressing these issues would help Iran achieve its objective of becoming one of the fastest growing emerging economies.

1. Iran’s fiscal policy has been procyclical, which usually leads to lower growth. By lowering investment during a downturn, fiscal policy became procyclical and amplified the impact of the shock. Cross-country experience also shows that procyclicality is harmful for growth (Fatas and Mihov, 2003, IMF 2015a), including for resource-rich countries (IMF 2015b), as lower investment can translate into lower growth performance, thus reducing the capacity of the economy to benefit from subsequent economic rebounds.

A01ufig01

Procyclicality and Growth in Resource-Rich Countries

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Source: Fiscal Monitor, 2015.Note: Procyclicalityis measured using country-specific regressions of real expenditure growth rateson commodity price changes.
A01ufig02

Real GDP Growth per Capita

(Percent)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff estimates.

2. Fiscal vulnerabilities also contributed to a low growth performance since 2008. Real GDP growth per capita has been almost zero percent on average, since 2008, after a decade of positive growth at 3¾ percent. Iran has faced a situation not uncommon to other resource-rich countries: shocks to oil prices have had a large impact on the economy, mostly because of the fiscal consequences of such shocks. Many factors aggravated the growth impact of these shocks, such as limited buffers (which could have otherwise been used to protect spending), large fuel subsidies (which constrain the fiscal space), and budget rigidities (such as arrears to private suppliers arising from limited expenditure controls and poor cash management practices).

3. Adverse oil revenue shocks have led to spending cuts. While the interim agreement with the P5+1 allowed Iran to stabilize its oil exports at about 1 million barrels per day (mbd), they remain below the pre-sanction period (of about 2¼ millions mbd before 2012). Oil exports were also negatively affected by declining oil prices (from $105 per barrel in 2012 to about $96 in 2014). Compared to the pre-sanction period, fiscal oil revenue declined from 12½ percent of GDP to about 6¼ percent. Since Iran had limited access to financing and the Oil Stabilization Fund (OSF) was no longer operational, the declining oil revenue translated into lower fiscal space for public spending. Infrastructure investment declined by 3 percentage points of GDP since 2012, and human capital investment (education and health) declined by 2½ percentage points.

A01ufig03

Oil Revenue and Investment Spending

(Average, percent of GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities and IMF staff estimates.

4. Budget fragmentation and rigidities exacerbate the lack of adequate buffers. Three main issues have affected budget execution: (i) the Oil Stabilization Fund (OSF) has not been operational since the creation of the National Development Fund of Iran (NDFI), which legally cannot finance the budget, (ii) Targeted Subsidy Organization (TSO) fiscal operations are not included in the budget and have contributed to the overall deficit, and (iii) weaknesses in expenditure controls and cash management have led to the accumulation of arrears.

  • Since the OSF is no longer used, the budget does not have a formal stabilization instrument. At present, the formula allocating oil export revenue between the NDFI and the budget does not factor the fiscal risks stemming from oil price fluctuations. The formula can still be adjusted in the budget law, as the authorities did for the 2015/16 budget to compensate for the sharp decline in oil prices. However, the current setup presents risks. The reliance on ad-hoc adjustments in the formula is insufficient to prevent disruptions in budget execution, notably on investment spending. Sudden stops in investment plans contribute to low investment efficiency and arrears, damaging potential growth and revenue collection.

  • Fiscal accounts cover mostly the central government, while quasi-fiscal operations, as well as contingent liabilities are not formally taken into account. Fiscal operations of the TSO are not fully integrated into the budget, which creates unexpected fiscal pressures when the TSO runs deficits. In addition, not integrating the TSO in the budget creates rigidities, as TSO revenue is de facto earmarked for specific transfers. Beyond the case of the TSO, the government fiscal reports do not cover other entities such as regional governments. Similarly, quasi-fiscal operations for government bodies (e.g., public foundations, nonfinancial public enterprises) are also not reported. Finally, contingent liabilities are not assessed (e.g., potential costs of recapitalizing public banks).

  • Limited expenditure controls and poor cash management practices led to the accumulation of arrears. Payment arrears have been accumulated and have not been formally accounted for. The vast majority of arrears are reportedly due to multi-year projects, and the authorities are doing a census of government arrears. In addition to weaknesses in expenditure controls, the lack of a formal Treasury single account hampers the ability of the government to manage cash effectively, and in some cases has favored the accumulation of arrears.

B. Future Challenges: Sustainable use of Oil Revenue, Aging Population, and Debt

Among the future challenges facing Iran, at least three would be essential to the need for designing a medium-term fiscal strategy. First and foremost, the sustainable use of oil revenue should be assessed. Second, fiscal policy would need to factor medium-term trends, risks, and vulnerabilities. For example, demographic pressures (in the short-term with new entrants in the labor market, and in the long-term with aging pressures) should be assessed and subsequently factored in the design of fiscal policy. Finally, fiscal policy would also need to factor in other macroeconomic objectives, notably inflation reduction, and limit risks of fiscal dominance for monetary policy.

A01ufig04

Nonoil Primary Balance

(Percent of nonoil GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff projections.
A01ufig05

PIH Under Different Assumptions

(Percent of nonoil GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff projections.

5. The need for additional development spending has to be balanced with a sustainable use of oil revenue. In the long run, one of the key challenges facing Iran is to balance the need for a sustainable use of its oil resources with the need for addressing development issues, through investment in human capital and infrastructure. Typically, fiscal policy could define the sustainable use of oil revenue through the permanent income hypothesis (PIH, see IMF, 2012 and 2015b), setting a benchmark on nonresource deficit, financed by returns on sovereign wealth. In the case of a country facing development needs like Iran, the PIH would typically be used in a “modified” form, relaxing the benchmark on the deficit over a period of time, to create space for additional development spending (see Baunsgaard and others, 2012, IMF 2012).2 Based on current conditions and IMF projections, the overall position of the general government departs from the standard PIH.3 However, this is not a cause of immediate concern, given the long-lasting hydrocarbon resources available.

6. Nevertheless, fiscal adjustment would be needed in the long term. It could be achieved either in the form of lower spending, increased non-oil revenue, and/or higher growth. From the PIH point of view, current policies are broadly consistent with a PIH restricted to a finite horizon of about 70 years. This would also correspond to Iran trying to take advantage of high and durable oil revenue to foster economic development of the non-oil sector. Finally, using the (modified) PIH, while helpful to quantify the fiscal space available, care should be taken when using it. Indeed, as shown in the graph above, because shocks to oil revenue can be large and persistent (notably on prices), the PIH can also be subject to large revisions following unexpected shocks. A decline of $20 in oil prices from $50 would result in a PIH-consistent deficit to fall from 5½ percent of non-oil GDP to about 3½ percent.

7. Iran’s public debt is low but risks warrant a prudent fiscal policy. At present, gross public debt is estimated at about 16 percent of GDP. Under the baseline, debt is projected to gradually decline over the medium term, owing to a prudent fiscal policy. While low and overall sustainable, risks related to growth and interest rates exist. Should they materialize, debt could rapidly increase from 16 percent of GDP to about 20 percent within two years. Currently, nominal interest rates on public debt are very low, leading to negative real interest rates and thus facilitating debt sustainability. However, the government is also engaged in a strategy of developing market-based instruments, notably to clear government arrears. Creating such instruments would require terms that are market-determined, which will increase interest payments, and, everything equal, increase public debt. Furthermore, the exact amount of public debt is not known precisely, as only a limited part of debt is recorded, namely central government debt owed to the banking system. Aware of these challenges, the authorities established a debt management unit within the Treasury in early 2015, with the primary task to identify all government debt. Preliminary estimates of Iran’s public debt are expected by end-2015. Overall, these risks would warrant incorporating them into a medium-term fiscal strategy, so that the government could assess correctly the gross borrowing needs and prepare plans to preserve debt at a sustainable level.

A01ufig06

Gross Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff projections.

8. Demographic pressures also warrant adequate fiscal planning. In the short term, the demographic pressures will mostly be felt through new entrants into the labor market, which underscored the need to promote a job-creating growth. Fiscal policy could support job creation through public investment (see next section). In the medium to long run, demographic pressures will be mostly felt through an aging population.4 These pressures may require fiscal planning to better prepare for additional age-related cost (health, pension), which could amount to about 2 percent of GDP annually. Cross-country experience shows that Iran may need to implement fiscal adjustment to make room for aging-related costs. In particular, public health spending is, on average, projected to increase by 1 percentage points of GDP annually in emerging countries (of which ⅓ percent is due to aging, the rest being owed to increased health cost, see Soto, Shang and Coady, 2012). However, Iran could incur higher costs, as the old-age dependency ratio would look similar to those of advanced economies in the long run. Those advanced economies are projected to face an increase in health-related spending by 3 percent of GDP over the long-run, of which 1 percentage point would be directly related to aging. Similarly, pension costs are expected to increase with population aging. However, in the case of Iran, potential liabilities are much more difficult to assess. The potential liabilities stem from three main areas: the overall pension system is pay-as-you-go, with defined benefits. This system generates fiscal risks for the future, especially with retirement ages relatively low (60 for men and 55 for women, with 20 years of contributions and options to take full retirement five years earlier with 30 years of contribution). In addition, Iran, like other emerging countries, faces a coverage issue, as some segments of the population are not fully covered, which could also translate into higher liabilities. Finally, pension funds have historically not been fully funded, with the government accumulating arrears in its contributions. Overall, while the pressures coming from population aging are more long term in nature, the magnitude of the potential cost would warrant advance planning, as it could have implications on the level of savings for future generations, and also because aging-related reforms often take some time to be adopted.

A01ufig07

Old-Age Dependency Ratio

(Percent)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Countries authorities, United Nations, Eurostat, and IMF staff calculations.

C. Options for a Medium-Term Fiscal Framework

In response to these vulnerabilities, the authorities identified fiscal policy as a key factor for stabilization and growth. In the design of their strategy, there are several areas that merit greater focus: (i) investing in infrastructure and human capital; (ii) increasing resilience to shocks, notably from oil prices, by increasing and diversifying sources of fiscal revenue; and (iii) implementing fiscal structural reforms (subsidy reforms, health coverage, improved expenditure management) to improve the overall efficiency and equity of public spending, especially in the domain of social spending.

Setting Fiscal Objectives in a Medium-Term Perspective

9. The main fiscal anchor could be the non-oil fiscal balance, coupled with objectives on the overall fiscal balance and expenditure.

A01ufig08

Fiscal Contribution to Disinflation

(percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff estimates and projections.
  • The non-oil fiscal balance could be the main fiscal indicator to be considered when setting Iran’s medium-term fiscal policy.5 The non-oil balance would be a particularly relevant policy tool for Iran, as it could be articulated around the modified PIH benchmark. It would also be a key indicator of the fiscal impulse provided to the economy and therefore, a good indicator on how fiscal policy supports macroeconomic stability goals. Looking forward, it would be essential to develop a fiscal strategy that would also consistent with macroeconomic stability, by targeting the non-oil fiscal balance and government deposit accumulation, to assist monetary policy.

  • The medium-term fiscal strategy would also need to target explicitly the overall fiscal balance. Currently, Iran has limited access to financing, and in this context, the overall fiscal balance would play a critical role in assessing the government borrowing requirement. Thus, the target on the overall fiscal balance could be also linked to the debt sustainability objective and/or fiscal buffers.

  • With the fiscal objectives set, the medium-term framework could then provide guidance on the expenditure level, consistent with the anchors and the expected revenue. Setting the expenditure level would be particularly helpful to assess (i) the space available for additional development spending in the short and medium term, and (ii) the need for fiscal adjustment to create space for higher age-related spending, or for higher interest payment, in the medium and long term.

10. Fiscal buffers need to be put in place to protect expenditure against oil price shocks. When deciding on the needed buffers, the authorities could consider the magnitude and duration of the shocks against which expenditure would be protected, with the understanding that beyond such a threshold, some procyclical adjustment may be unavoidable. Over the past 20 years, expenditure has been volatile, with a standard deviation of about 2¾ percentage points of GPD. This is broadly consistent with the impact of the oil revenue shock over the past few years, which resulted in spending cuts of about 2½ percentage points of GDP. Thus, buffers could be set so as to absorb potential shocks of about 2½ percent of GDP, over five years, consistent with the duration of Iran’s development plans. Protecting in full the outer years of each plan could be balanced with the prospects of plans being adjusted as shocks occur. There are two alternative options for buffers (chart). One is a “conservative” buffer, built to protect expenditure for each year, which would require a buffer of 12½ percent of GDP. Alternatively, a “flexible” buffer only covering in full the first two years, would require a buffer of 7¼ percent of GDP. The flexible buffer would be comparable to the current size of the NDFI. An option to consider would be to transfer part of NDFI deposits into the OSF. Looking forward, the need for buffers in the form of financial assets could be reduced with Iran gaining greater access to domestic and international financial markets. In particular, the development of government securities would provide additional buffers to protect budget execution against large swings in fiscal revenue, and help with developing domestic capital markets. Finally, when designing buffers, the authorities could also consider planning for future generations, especially in the context of an aging population.

A01ufig09

Precautionary Savings

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: Iran authorities, and IMF staff estimates.

Reducing Budget Fragmentation and Improving the PFM System

11. A successful fiscal strategy should rely on an improved PFM system, centered on consolidated fiscal accounts and transparency. In particular, fiscal accounts of the central government, TSO, and the NDFI should be consolidated to present the overall fiscal position of the general government, in line with best practices. The coverage could then be, over time, extended to cover the whole public sector. Also, prudent revenue forecasts, notably on oil prices, would help prepare expenditure plans as well as building buffers. In parallel, efforts would need to be made to avoid the occurrence of payment arrears, through improved commitment controls and strengthen cash management. Other PFM reforms would be needed to achieve these objectives, such as establishing a single Treasury account or developing a new Government Financial Management Information System (GFMIS).

12. In addition to strengthening the budget process, efforts should be made to disclose fiscal risks and improve transparency. One crucial hurdle in the process of developing buffers and maintaining a prudent fiscal policy will be to gather sufficient political and social support for such a policy. Faced with numerous development challenges, demand for new spending programs is likely to be strong, especially if the fiscal position were to improve following the removal of sanctions. In this context, it would be essential to adhere to sound principles in disclosing fiscal risks, notably those related to oil revenue shocks. This would help muster support for re-establishing and preserving buffers and maintaining a prudent fiscal stance, which are essential to ensure that Iran meets its development goals. Similarly, the cost of fuel subsidies could be fully disclosed in budget documents, and efforts to strengthen public expenditure efficiency (e.g., evaluating investment projects, developing social safety nets), could also be made transparent in order to facilitate a broad consensus over key fiscal objectives.

Meeting Iran’s Development Goals with Scaled-Up Investment

13. Scaling up investment in Iran could support employment and growth goals, provided it is done prudently. In the simulations presented, investment is scaled up from 2016 on for a period of 6 years, followed by fiscal adjustment for 10 years, where fiscal policy would gradually return to the PIH (See Annex I for more details, and Table 1). The magnitude of scaling up is quite significant, with capital expenditure jumping from 4 percent to 7 percent of GDP during that phase. Assuming an elasticity of growth to investment of 0.1, the simulations show an improvement in growth performance, which translates into higher revenue, and eventually reduce the need for an “active” fiscal adjustment (i.e., fiscal measures). The specific numbers retained in the simulations show that the net financial wealth would still be high, thus providing, potentially, enough buffers. However, as shown in past years, adverse shocks to oil revenue can disrupt significantly spending plans, and for that reason prudence is required if net financial wealth was to decline too rapidly. This would strongly advocate for developing adequate fiscal buffers, as well as assessing fiscal risks within a comprehensive fiscal framework.

Table 1.

Islamic Republic or Iran: Oil Revenue Management and Public Investment

article image
Source: Iran authorities, and IMF staff estimates and projections.

Unchanged policies scenario (UP). The composition and level of expenditure would remain similar to the latest exeduted budget (fiscal year 2014/15) and consistent with a nonoil fiscal balance broadly constant in percent of nonoil GDP.

Permanent income hypothesis with an time horizon of 70 years (PIH(70)). Primary expenditure would be adjusted to a level consistent with a depletion of the wealth generated by oil revenue within the next 70 years.

Permanent income hypothesis with an infinite time horizon (PIH). Primary expenditure would be adjusted to a level consistent with the preservation of a level of the wealth generated by oil revenue consistent with an infinite stream of revenue that would finance the nonoil fiscal balance.

Modified PIH (MPIH). With an investment-scaling-up program, part of the wealth generated by oil revenue would be used upfront to boost growth performances. This would be at the expense of a lower permanent stream of revenue to finance the nonoil fiscal balance.

14. Committing to a fiscal adjustment over the medium term, while ensuring productive and growth-friendly investment, is a key objective. Fundamentally, the scaled-up investment would need to be offset by a lower non-oil deficit in the future. There are three main issues to address in order for scaling-up to be successful:

  • public investment efficiency can be low (Pritchett, 2000, Gupta and others, 2014), which can be mitigated by improved public investment management (Dabla-Norris et al., 2012), as well as fiscal buffers to prevent sudden stops in investment projects due to lack of funding;

  • supply bottlenecks, which can translate into slower scaling-up, as well as increased prices and wages due to increased demand for raw materials and labor (Sachs and Warner 2001, Van der Ploeg, 2010), thus reinforcing the “Dutch disease” effect of natural resource exploitation; and

  • the overall quality of public institutions, as political economy pressures can channel public investment towards groups who get more traction from policy makers, at the expense of social and economic goals (Van der Ploeg, 2011, Arezki and Brueckner 2011, Arzeki and others, 2011).

To address these potential vulnerabilities, the authorities could carefully assess the pace at which investment would be increased; ensure that investment projects are properly evaluated in terms of costs and benefits, and that fiscal buffers are developed. More generally, Iran could consider first building up capacity to manage and absorb investment, a process dubbed “investing in investment” (Collier, 2011, Berg and others, 2012).

Expenditure and Tax Policies to Reduce Dependency on Oil Revenue

15. Increasing the share of non-oil revenue would help build space for development spending while preserving overall fiscal deficit objectives. A key element of the medium-term fiscal strategy would be to increase the share of domestic revenue. The authorities have taken steps in this direction, by gradually increasing the VAT rate over the past few years, removing tax exemptions, and taking steps to strengthen the administrative capacity of the Iranian tax administration. At present the VAT rate is 9 percent, and the authorities have considered increasing it to 10 percent, which would bring Iran closer to the rates in some comparator countries. Increasing the share of VAT in total revenue would also be in line with good practices (IMF 2013c) and tends to provide more growth-enhancing results than increasing the share of income tax (Acosta-Ormaechea and Yoo, 2012). Also, increasing the share of domestic revenue would help reduce dependency on oil revenue, by increasing the share of current expenditure financed by domestic taxes, thus allocating more oil revenue to public investment financing, which would be appropriate with the overall strategy of scaling-up investment over the short and medium term.

A01ufig10

VAT Rates Accross Ressource-Rich Countries

(Percent)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: International Bureau of Fiscal Documentation, IBFD, 2013 (www.ibfd.org).
A01ufig11

Fuel Price Subsidies and TSO Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A001

Sources: IEA, Iran authorities, and IMF staff estimates and projections.

16. Implicit fuel subsidies remain large and could be reduced further. Fuel subsidies have been significantly reduced, currently at about 4 percent of GDP, while the TSO had incurred deficits. Iran, like many other oil producers, has provided implicit subsidies to domestic fuel prices and to basic food items. Aware of the inefficiency and costs of such subsidies, the authorities defined a strategy to capture the rent generated by them. Domestic fuel prices have been adjusted in 2014, with price increases ranging from 20 to 75 percent and in mid-2015, with further increases from 20 to 40 percent. Coupled with the decline in international prices, fuel subsidies are projected to decline from 10½ percent of GDP in 2012/13 to about 4 percent in 2015/16. In parallel to reducing implicit subsidies, the TSO was set up to provide cash transfers to the population, financed by the rent captured through fuel price increases. The TSO contributed to pressures on the budget, with annual deficits of about 1½ percent of GDP in 2012/13 and in 2013/14. Thus, a significant part of the strategy should also focus on reducing fuel subsidies further. The authorities could consider a rule-based price adjustment, so that adjustments would become automatic, while developing social safety nets to protect the poor, notably through targeted cash transfers.

Would Rules Help Fiscal Policy?

17. Iran could consider introducing fiscal rules to help anchor a sustainable use of oil revenue. A price smoothing rule could be considered, to guard against the large and unpredictable price shocks. It could be coupled with expenditure rules, to guard against too rapid increase in spending during booms, thus protecting the buildup of buffers for bad times (Baunsgaard and others, 2012, IMF, 2005, 2009, and 2010). However, to be effective, such rules would need to be built around a comprehensive medium-term fiscal framework, and adequate PFM system, two key issues that remain to be addressed in Iran. Setting rules, for example, while the coverage of fiscal reports is limited to the central government, and fiscal policy objectives are not clearly defined or articulated in a medium term perspective would jeopardize the effectiveness of such rules. Also, a price smoothing rule would need to rely on reinstating the OSF (or an equivalent mechanism), and care would be needed to ensure that the OSF has an adequate transparency and governance structure, to avoid that governance issues lead to abandoning the mechanism. However, if successful, fiscal rules could lead to additional benefits: higher welfare than discretion (Barro and Gordon 1983, Drazen 2000), as well as lower risk premia (Hallerberg and Wolff, 2006). However, in resource rich countries, while there has been some notable successes (Chile, Norway, and Botswana) cross-country evidence suggests that, in general, rules have not significantly reduced procyclicality (IMF, 2015b). The reasons for this lack of success are varied, and often comes down to the overall fiscal policy framework, with either weak PFM systems leading to off-budget spending, or simply lack of broad political and social support for the rules.

18. Compliance with fiscal rules could also be facilitated by legal foundations (and not just political commitment) and independent monitoring. Another critical issue to address when developing fiscal rules is the incentives they create for nontransparent behaviors and/or “creative accounting”, where policy makers seek to comply only seemingly with the rules. Fiscal rules should imply costs for policy makers in case of nonenforcement, either in terms of reputational costs for ruling parties or in terms of legal sanctions that require specific actions. A law-based rule would imply penalties in case of noncompliance, and thus increases chances for rules to be implemented.

In addition, the use of independent bodies to monitor rules can also strengthen incentives for compliance, by increasing the political cost of deviation (IMF, 2013a).

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Appendix I. The Permanent Income Hypothesis

Definition

The net present value of expected oil-related fiscal revenue at date t can be viewed as a financial asset, AT, which can either be used to finance a permanent income (i.e. with an infinite time horizon), or an income over the definite period of time (in our case a time horizon of 40 years), after which the financial asset is fully depleted.

AT can be defined as:

AT=τ=0TRτ(1+i0)1Πτ=0j(1+iτ)(1)

With Rt the oil revenue at time t, and it the real interest rate. T is a time horizon for the depletion of oil resources. Assuming a constant interest rate ithroughout the projection horizon the equation becomes:

AT=τ=0TRτ(1+i)τ(2)

With an infinite time horizon, the permanent income that can be derived from the financial wealth (the PIH), is defined as:

A=τ=0+PIH(1+i)τPIH=Ai1+i(3)

Under a finite time horizon of T years, the PIH is defined as:

t<T;AT=τ=0+TPIH(1+i)τPIH=ATi1+i(11(1+i)(T+1))(4)
t>T;PIH=0(5)

Evaluating the PIH for Iran

Three broad categories of parameters enter in the computation of the PIH, including the modified version where investment is scaled-up.

Oil revenue throughout the long term. Three key parameters here are total oil production, oil prices, and the share of government revenue in total oil production. In the computations provided in this paper, oil production is assumed to be gradually increased to about 4,000 barrels per day by 2020, before increasing further to 8,000 over the long run. A lower level of production would translate into a lower PIH-compatible deficit. For example, a production of 6,000 bpd over the long term would roughly lead to a PIH deficit lower by % percentage point. Oil prices are based on WEO projections in the baseline. As stressed in IMF (2015), oil prices as hard to predict and basically behave as a random walk. As a result, any computation of PIH for a country like Iran, with long-lasting reserves, is highly uncertain. As an example, oil prices lower by 50 percent would reduce the PIH deficit by about 1 percentage point. Finally, the share of government revenue in total oil revenue has also a critical impact on the PIH. The baseline projection assumes a share corresponding to actual numbers, of about 45 percent. However, this share is de facto primarily driven by oil exports, as domestic fuel prices are still subsidized and reduce the rent captured by the government. Increasing the share of government revenue could also be a tool for government to mitigate the negative risks of negative shocks occurring in the long term.

Long-term growth potential of the non-oil sector. In the assumptions real GDP growth would remain stable at 4¼ percent throughout the medium-term. This would correspond to roughly a GDP per capita increasing, in real terms, at about 3¼ percent over the medium term, and also over the long term, as a result of aging and population gradually declining. Such a growth path would represent a dramatic change from the 2008-14 period, where the economy barely grew in per capita terms, but also an improvement compared to the period 1995-2007, which averaged a GDP growth per capita of 3¼ percent. Iran has the capacity to achieve such a growth rate, given the well-educated population and the growth potential represented by an already large non-oil sector. In addition, the prospects of lifting sanctions could trigger a virtuous cycle of increased integration with the global economy that would help attract investment and develop business opportunities in Iran. However, hurdles remain, as Iran still has a weak business climate by international standards, as assessed by the World Bank’s Doing Business assessment. Also the macroeconomic policy framework would need to promote a private-sector led growth, which in turn could require further public investment, while mitigating inflationary pressures. Overall, while the assumption of a long-term real GDP 4¼ percent is achievable, it will still represent challenges, which could partly be addressed by prudent fiscal policies geared towards quality public investment (see below).

Parameters to Compute the PIH

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Source: IMF staff.
1

Prepared by Olivier Basdevant.

2

A key rationale for relaxing the PIH would be to compensate for credit constraints and/or capital scarcity, while taking advantage of potential high return on public investment (Sachs and Warner 1999, Van der Ploeg and Venables, 2010, Venables, 2010, IMF, 2012). While Iran access to finance could be greatly improved in the coming years once sanctions are lifted, it could still be appropriate to first consider using oil revenue for additional investment.

3

The overall approach of oil revenue management is, for the purpose of the exercise, to analyze the general government fiscal position, defined at the central government, the Targeted Subsidy Organization (TSO) and the National Development Fund of Iran (NDFI). At present the NDFI formally deposits revenue at the central bank, which is then on-lend to the private sector. However, it remains uncertain if these loans would be indeed ever reimbursed, and for simplicity they are accounted for as government expenditure in the exercise.

4

According the UN population projections, the old-age dependency ratio of Iran would sharply increase in about 20-30 years, to reach about 50 percent in the long term, a level comparable to other emerging and advanced countries facing serious aging issues.

5

In terms of scaling, the non-oil GDP is usually a more appropriate deflator, as total GDP may be too sensitive to oil price fluctuations.

Islamic Republic of Iran: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.