From Stimulus to Consolidation - Revenue and Expenditure Policies in Advanced and Emerging Economies

This review marks the 10th anniversary of the safeguards policy. Introduced in March 2000, the policy’s main objective is to mitigate potential risks of misuse of resources, including Fund resources, and misreporting of monetary program data. The policy was last reviewed in 2005, when the Executive Board re-affirmed the effectiveness of the policy, and its application to central banks. In keeping with previous reviews, a panel of experts was invited to provide advice for the Executive Board on the implementation of the policy, and recommendations to guide the focus and application of the policy going forward.

Abstract

This review marks the 10th anniversary of the safeguards policy. Introduced in March 2000, the policy’s main objective is to mitigate potential risks of misuse of resources, including Fund resources, and misreporting of monetary program data. The policy was last reviewed in 2005, when the Executive Board re-affirmed the effectiveness of the policy, and its application to central banks. In keeping with previous reviews, a panel of experts was invited to provide advice for the Executive Board on the implementation of the policy, and recommendations to guide the focus and application of the policy going forward.

Executive Summary

This paper identifies policy tools to support fiscal consolidation in the years ahead. Its starting point is the analysis in the recent Board papers describing strategies for fiscal consolidation (IMF, 2010a, 2010b), which showed that on current trends, general government debt in advanced countries would rise 36 percentage points of GDP during 2007–14, and that age-related spending (health and pension) would rise rapidly later, further adding to fiscal pressures. Trends are more favorable in emerging economies, but adjustments are needed there too.

The consolidation strategy, particularly in advanced countries, should aim to stabilize age-related spending in relation to GDP, reduce non-age-related expenditure ratios, and increase revenues in an efficient manner. The precise mix will vary across countries, but given the high level of taxation in advanced countries and recent increases in spending, a relatively stronger effort is needed on expenditures.

On the spending side, bold reforms are needed to offset the projected rise in age-related outlays, particularly health care. In pensions, a further increase in statutory retirement ages of two years could offset the projected rise of spending of 1 percentage point of GDP over the next 20 years in advanced economies. In health, the challenge is greater, and has so far been underestimated, particularly in Europe. New staff projections show that health spending could rise by 3½ percentage points of GDP over the next 20 years in advanced countries. Reforms are needed to address supply-side incentives, limit public benefits, or reduce the demand for public health services. But while many countries have managed to reform significantly their pension systems, the difficulty of health reform is underscored by the dearth of prominent reforms in advanced countries aimed primarily at reducing spending.

In other spending areas, in addition to allowing stimulus spending increases to expire, a possible policy goal could be to freeze spending in real per capita terms for 10 years. This would save 3–3½ percentage points of GDP. It would require deep spending reforms. Containing the wage bill has in the past proved to be key to successful fiscal consolidation. Expenditure on social benefits could be reduced, without sacrificing equity objectives, through better targeting. Subsidy spending should also be lowered, including for petroleum products, which absorb about 1 percent of world GDP. There may also be scope for savings on military spending.

On the revenue side, boosting revenues in a global economy requires strengthening broad-based taxes on relatively immobile bases and improving tax compliance, including through better international cooperation. Relatively efficient measures could yield perhaps 2.8 percent of GDP (on a weighted average basis) in G-7 countries from: increasing the yield of the VAT by eliminating exemptions and reduced rates; further developing property taxes; increasing excise rates within the scope of rates already applicable in comparable countries; and introducing (and capturing revenues from) efficient carbon pricing in the United States and Europe. A menu of additional measures—for instance, introducing VAT in the United States, and doubling the very low VAT rate in Japan—could further raise revenues by 4.5 and 2.6 percent of GDP, respectively, in those countries. There is also scope for stronger income taxation, in part to address equity objectives, though efficiency concerns loom larger there. Strengthening tax compliance requires renewed efforts to tackle aggressive tax planning, evasion, and fraud. The potential for improvement here too is large. For example, VAT evasion is estimated to average 0.7 percent of GDP in advanced countries.

I. Introduction

A. Overview

1. This paper seeks to identify policy tools that could be used for fiscal consolidation in advanced and emerging countries in the wake of the global financial crisis. Issues related to the size and timing of fiscal adjustment, policy coordination, and demand management were addressed in previous papers (IMF, 2010a, 2010b).

2. The magnitude of the challenge to revenue and expenditure policies is large, including in light of projected increases in age-related spending. The effects of the crisis have been severe, particularly in advanced countries:

  • In advanced countries, primary deficits rose by 7½ percentage points of GDP between 2007 and 2010, reflecting underlying spending increases, stimulus measures, and cyclical factors (IMF, 2010a, 2010b, 2010c).2 These increases have come on top of an already rising spending trend, in real per capita terms and also relative to GDP, during this decade (Table 1a). Revenues have declined in real terms owing to the collapse in assets prices, financial sector profits, reduced output, and possibly, reduced tax compliance. As a result, general government gross debt is projected to rise by 36 percentage points of GDP between 2007 and 2014. To reduce it to, say, 60 percent of GDP by 2030, an average improvement in the structural primary balance of 8¾ percentage points of GDP on a PPP-weighted basis (unweighted average, 4¾ percentage points of GDP) would be required between 2010 and 2020 (IMF, 2010b, 2010c).3 This would have to be achieved at a time when age-related spending (health and pensions) will tend to rise by about 4–5 percentage points of GDP; and

  • In the emerging economies, revenue growth in 2008–10 has experienced a marked slowdown from the rapid increases observed in the pre-crisis period (2001–07). Primary spending has also been rising rapidly in real terms at a slightly faster pace compared to the pre-crisis period (Table 1b). In these countries, the need for adjustment is less severe—on average, 2¾ percentage points of GDP, if the goal is to reduce public debt to a ratio of 40 percent of GDP by 2030.

Table 1a.

Advanced Economies: Revenue, Expenditure, and Illustrative Adjustment

(General government, unless otherwise noted)

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Sources: WEO; and IMF staff estimates.Note: For a description of illustrative adjustment, see footnote 3 of text and notes for Figure 1. The illustrative adjustment refers to the change in the cyclically adjusted primary balance needed to stabilize debt at the end-2012 level by 2030 if the respective debt-to-GDP ratio is less than 60 percent (no shading) or to bring the debt ratio to 60 percent in 2030 (shaded). Figures for Greece incorporate latest IMF program data that assume an adjustment of 7.6 percent of GDP in 2010. For Australia, the figures do not take account of the latest federal government budget, released on May 11, which envisages a return to federal government surpluses by 2012-13.

Central government.

Earliest year consistent WEO revenue and expenditure growth series available: 2002.

Table 1b.

Advanced Economies: Revenue, Expenditure, and Illustrative Adjustment

(General government, unless otherwise noted)

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Sources: WEO; and IMF staff estimates.Note: For a description of illustrative adjustment, see footnote 3 of text and notes for Figure 1. The illustrative adjustment refers to the change in the cyclically adjusted primary balance needed to stabilize debt at the end-2012 level by 2030 if the respective debt-to-GDP ratio is less than 40 percent or to bring the debt ratio to 40 percent in 2030.

Nonfinancial public sector.

Earliest year consistent WEO revenue and expenditure growth series available: 2002.

Central government.

Earliest year consistent WEO revenue and expenditure growth series available: 2005.

Earliest year consistent WEO revenue and expenditure growth series available: 2003.

3. The adjustments needed to achieve these debt targets vary substantially across countries. For example, among advanced economies, about two-thirds face primary adjustment needs lower than 5 percentage points of GDP, while one-fifth require adjustments greater than 8 percentage points of GDP. These differences reflect variations, not only in initial debt positions, but also initial primary structural balances. The adjustments needed to offset age-related spending pressures also vary, depending not only on demographics and income levels, but also the coverage and generosity of the systems (Figure 1).

Figure 1.
Figure 1.

Illustrative Fiscal Adjustment and Projected Age-Related Spending Increases in 2011–30

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Source: IMF staff estimates.Notes: Fiscal adjustment refers to improvements in the cyclically adjusted primary balance needed to achieve the illustrative gross general government debt target. Circles indicate debt ratios above 60 percent for advanced economies and 40 percent for emerging economies, projected at end 2012; triangles indicate debt ratios below 60 percent for advanced economies and 40 percent for emerging economies, projected for the same period. For Japan, the target is 200 percent of gross debt (close to the pre-crisis level); even with this less ambitious target, Japan has the highest needed adjustment among all countries. For Greece (not shown), the comparable figures for required adjustment and health and pension spending increases are 9.2 and 7.6 percent of GDP, respectively; this assumes an adjustment of 7.6 percent of GDP is implemented in 2010. For Australia, the figures do not take account of the latest federal government budget, released on May 11, which envisages a return to federal government surpluses by 2012–13. The analysis is illustrative and makes some simplifying assumptions: in particular, up to 2015, an interest rate-growth rate differential of 0 percent is assumed, broadly in line with WEO assumptions, after 2015 differential is 1 percent for all countries. For details on methodology and the country- specific estimates, see IMF (2010b and 2010c) and footnote 3 in the text. For a description of projected increases in age-related spending, see Section II. The vertical and horizontal lines represent unweighted averages.

4. The paper is structured as follows. The rest of this introduction sets out general considerations for balancing revenue and spending measures to achieve fiscal consolidation. Section II identifies reform options for public spending, also based on new staff projections for age-related spending for a large number of advanced and emerging economies. Section III considers reform options in tax policy and administration. Section IV proposes some issues for discussion.

B. Balancing Revenue and Expenditure Measures in Adjustment Strategies

5. The appropriate mix of adjustment measures will depend on various factors, although, on average, higher reliance on spending cuts will likely be needed, particularly in advanced countries. The literature generally finds expenditure-based adjustments to have been more successful.4 Looking ahead, the mix between revenue and expenditure measures should reflect:

  • Current spending and revenue levels. With tax burdens high in many advanced countries, there may be limited scope to raise tax rates without adverse effects on economic efficiency, with some exceptions, notably carbon pricing. This—together with the fact that the stimulus measures consisted primarily of spending increases, as well as the need to offset the trend increase in age-related spending—will imply higher reliance on spending cuts. But the extent of this will vary with preexisting tax design and implementation: closing the gaps in a porous VAT, for instance, can provide a relatively efficient source of substantial revenue, even in countries with relatively high tax-to-GDP ratios;

  • Size of the needed adjustment. Where this is large, substantial measures are likely needed on both the revenue and expenditure sides. The unprecedented magnitude of the required adjustment will most likely also require revenue measures in many countries. In most advanced economies, for example, a freeze on real per capita expenditures (other than health and pension outlays) over the next 10 years would be insufficient to generate the needed adjustment as shown in the illustrative scenario (IMF, 2010b);

  • Impact of reform measures on growth and equity. This would suggest a strong emphasis on reform of inefficient, poorly targeted, and inequitable public spending. In some cases, offsetting measures, such as stronger and better-targeted social safety nets, may be needed to address the effects of reforms; and

  • Socio-political views on the role of government. Where there is consensus on a relatively larger role for government, basing fiscal consolidation on revenue expansion may find broader support.

6. Reflecting these considerations, the focus of country adjustment strategies will vary (Table 2). The guidelines below should be seen in the context of strategies for fiscal consolidation, rather than longer-term development goals that could influence revenue and expenditure plans:

  • Where both adjustment needs and tax effort are relatively low, revenue-raising is naturally the main focus (Indonesia and Mexico);

  • Where adjustment needs are low and the impulse from spending has been high, or the tax level is relatively high, adjustment should rely more on expenditure reductions (Argentina, Brazil, Russia, Saudi Arabia, Sweden, and Turkey)—including through improvements in the efficiency of spending. In addition, where there is scope for improving revenues, reforms should include measures in this area (Iceland);

  • For countries with moderate/high adjustment needs, and where structural expenditure has risen rapidly during the crisis and is at a medium to high level, the strategy should focus on expenditure reductions (Australia, Belgium, Canada, Finland, Netherlands, Poland, and South Africa). This is particularly the case where the desire or options for increases in taxes are limited. For others, possibilities for efficiency-enhancing revenue measures, including through administration reforms, should be fully explored (Austria, Germany, and Italy). In addition, where there is scope for significantly improving revenues, reforms should include measures in this area, as well as a reversal of stimulus spending (China);

  • Some countries with high adjustment needs will require measures on both sides. This includes France, Greece, India, Ireland, Japan, Portugal, Spain, the United Kingdom, and the United States; and

  • All countries will need to develop a strategy to deal with age-related expenditures. For advanced countries where spending pressures are higher, a reasonable goal would be to keep these outlays constant (relative to GDP) over the medium term. For emerging market economies, the focus would be on improving the efficiency of this spending and program design at an early stage, to ensure that the expansion of coverage over the longer term is fiscally sustainable.

Table 2.

Selected Advanced and Emerging Economies: Adjustment Strategy and Illustrative Adjustment Needs

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Note: Adjustment needs are defined as in Figure 1, horizontal axis. Therefore, they exclude the measures needed to offset age-related spending increases.

II. Expenditure Reform

A. Expenditure Reform: Key Principles

7. Expenditure reforms should be guided by two objectives:

  • Improving the efficiency of spending. Countries should seek to reduce the cost of producing existing public sector outputs. In addition, spending should be allocated to activities that provide the greatest marginal benefits to society as a whole; and

  • Ensuring equity. Growth without equity is less durable (Berg, Ostry, and Zettelmeyer, 2008; and Tanzi, Chu, and Gupta, 1999). Expenditure policy must reflect the need for both intra- and intergenerational equity. In view of demographic pressures, ensuring intergenerational equity will require altering the terms of social insurance in many countries. Greater targeting of social spending may also be necessary to ensure that the poor are protected as spending levels are reduced as a share of GDP.

B. Expenditure Structure and Trends

8. Cross-country differences in the size and composition of government spending are sizeable, reflecting differences in the level of development, role of the state, and spending efficiency. Expenditure is generally higher in advanced economies, reflecting more expansive social benefits (Tables 3a and 3b). There are also significant variations within the advanced economies, reflecting differences in demographic structure and socio-political preferences regarding the role of government. Outlays for the wage bill are higher in advanced than emerging economies. Capital expenditures are generally higher in emerging economies, but with wide variation across countries. Although high spending alone does not indicate inefficiency, several studies suggest that many countries could achieve similar levels of public services in education and health at a lower cost (Carcillo, Gunnarsson, and Verhoeven, 2007; and Afonso, Schuknecht, and Tanzi, 2005 and 2006).

Table 3a.

Expenditure Structure: Advanced Economies, 2008

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Sources: WEO; Eurostat; GFS; and OECD.

2007 data.

Government Financial Statistics (GFS).

Eurostat; capital spending proxied by “gross fixed capital formation.”

WEO.

2006 data.

OECD; capital spending proxied by “gross fixed capital formation.”

2005 data.

Table 3b.

xpenditure Structure: Emerging Market Economies, 2008

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Sources: WEO; Eurostat; GFS; ILO; and IMF staff estimates.

WEO.

ILO Social Security Department database Global Extension of Social Security (GESS), accessible at http://www.socialsecurityextension.org/gimi/gess/ShowTheme.do?tid=1985.

Eurostat; capital spending proxied by “gross fixed capital formation.”

“Social benefits” include social security benefits only.

2007 data.

GFS.

Public pensions only.

IMF staff estimates.

9. Age-related spending has been the main driver of current spending over the past two decades. Within the advanced countries, age-related outlays have risen since 1990 by roughly 2 percentage points of GDP (Figure 2). Increases have been especially large for pensions in Japan and Korea in the past decade, and for health spending in Korea (from a low level) and France, Greece, and Portugal. Demographics have been an important catalyst behind these increases, particularly in pensions, in the advanced economies. For health, technology5 and its interaction with an ageing population have been the key drivers behind rising spending. These trends are expected to continue in the coming years for both advanced and emerging economies (see Section D).

Figure 2.

Age-Related Expenditure Trends in the Advanced Economies

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: OECD; WEO; and IMF staff estimates.Note: Countries included in the sample are Australia, Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States

10. Reinforcing past trends, primary current expenditures, adjusted for the cycle, have risen further during the crisis. After the success of the 1990s in containing spending increases as a percent of GDP—owing to reductions in non-age-related outlays—primary current spending began drifting upward in the years prior to the crisis, but with wide variation across countries (Figures 2 and 3; and Appendix Figures 15 and 16). In some countries with moderate and high adjustment needs, current primary spending was already rising in 2000–07, including for wages (Italy, the United Kingdom, and the United States). Primary current spending also increased steadily in many emerging economies such as Argentina, Brazil, Mexico, and South Africa (Appendix Figure 17). Since the crisis, current outlays have accounted for the bulk of the rise in spending in the advanced G-20, partly reflecting safety net spending. Of the increase in structural spending of about 2½–3 percentage points of GDP in the advanced G-20 economies between 2007 and 2010, about 1½ percentage point can be attributed to discretionary stimulus measures. In the emerging G-20, primary balances have weakened due to higher spending, especially for social benefits, the wage bill, and public investment.

Figure 3.
Figure 3.

Primary Expenditure Trends in the Advanced Economies

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: OECD; WEO; and IMF staff estimates.Notes: Countries included in the sample are Australia, Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States; and the dashed line represents percent of potential GDP.
Appendix Figure 15.
Appendix Figure 15.

Advanced G-20 General Government Primary Expenditure Trends 1990–2008: Economic Classification

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: Eurostat; and OECD.
Appendix Figure 16.
Appendix Figure 16.

Advanced G-20 General Government Primary Expenditure Trends, 1997–2008: Functional Classification

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: OECD; and Eurostat.Notes: Or latest year available; averages are PPP GDP weighted.
Appendix Figure 17.
Appendix Figure 17.

Emerging G-20 Primary Public Expenditure Trends, 1995–2008: Economic Classification

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: WEO; and IMF staff estimates.1/ Nonfinancial public sector.2/ Central government.3/ General government.4/ PPP GDP weighted.

C. Expenditure Reform Strategy

11. In countries requiring fiscal consolidation, the adjustment on the spending side will have to go well beyond the expiration of the stimulus spending increases; more fundamental reforms are needed. Non-renewal of the stimulus spending would lower spending by 1½ percent of GDP in the advanced and emerging G-20 economies, only a fraction of the needed adjustment.

12. A two pillar strategy could anchor expenditure reform, guided by the following objectives (IMF, 2010b):

  • Stabilize age-related spending relative to GDP. Given the major trend increase in these outlays, reducing this spending would be difficult. The goal should thus be to stabilize spending-to-GDP ratios, which will require significant structural reform.

  • Reduce non age-related spending relative to GDP. A possible policy goal would be to stabilize aggregate non-age-related spending in real per capita terms so that the ratio of GDP drops as growth picks up. In the advanced economies, for example, freezing non-age-related spending in real per capita terms over the next 10 years—beyond the savings arising from the non-renewal of stimulus spending—could generate structural savings of about 3–3½ percentage points of GDP.6 Similar policies helped underpin some successful fiscal consolidations in the 1980s and 1990s, such as in Belgium (1983–89), Denmark (1982–86), Finland (1993–2000), Israel (1980–83), and Sweden (1993–2000).

13. To achieve these goals, medium-term expenditure reforms will need to improve the composition and efficiency of expenditure. The freeze in real spending is an overall policy goal, not a tool. Targeted structural reforms would be needed to achieve this goal. In both advanced and emerging economies, reforms in wages, subsidies, and transfers have been the most durable and conducive to economic growth.7 Staff analysis of the experience with large fiscal adjustments provides a similar picture, with cuts in the wage bill comprising about a quarter of the adjustment and social benefits and transfers accounting for almost a third (Appendix Table 15). Containing age-related spending has also been an important element of the adjustment.8 A breakdown by functional classification shows that reductions in general public services, economic affairs, and defense spending have comprised an important element of adjustments among advanced economies in these episodes (Appendix Table 16).

Appendix Table 15.

Country Experiences with Large Fiscal Adjustment: Economic Classification and Age-Related Spending

(In percent of GDP)

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Sources: WEO; Eurostat; and OECD.Note: Data reflect both cyclical and structural factors; averages are unweighted.
Appendix Table 16.

Country Experiences with Large Adjustment: Functional Classification

(In percent of GDP)

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Sources: WEO; Eurostat; GFS; and OECD.Note: Data reflect both cyclical and structural factors; averages are unweighted.

14. Better targeting of social welfare spending, including social benefits, could provide substantial fiscal savings. Social benefits are large—both in percent of GDP and as a share of spending—in many countries with high adjustment needs (Tables 3a and 3b). 9 Much of this spending, however, is not well targeted. In the OECD, less than 10 percent of public social spending is means-tested (Adema and Ladaique, 2009). This partly reflects a high share of age-related, insurance-based outlays in social spending. Nonetheless, the effectiveness of cash transfers in reducing inequality varies considerably, even among countries with similar systems (ILO, 2010, OECD, 2008a). In the European Union, less than a third of non-age related benefits are means-tested (Figure 4). This suggests substantial scope to reduce these outlays without sacrificing equity objectives. Improved targeting of tax benefits (including for employer-provided benefits) should also be explored, with due consideration of the implied increase in marginal tax rates (see also ¶55).

Figure 4.
Figure 4.

Targeting of Non Age-Related Social Spending, 2007

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Source: Eurostat.Note: Non-age related social spending reflects social benefits excluding old-age and health spending.

15. The design of unemployment benefits could be improved. As employment recovers, spending programs providing long-term assistance to the unemployed should be reexamined. The high long-term replacement rates of unemployment benefits in some countries, for example, can have high fiscal costs and adverse labor market effects (OECD, 2009b) (Figure 5). Staff estimates that in countries with above-average replacement rates, reducing them to the OECD average could yield savings of almost ½ percent of GDP. Efforts to tighten the duration and generosity of out-of-work benefits, with increased emphasis on in-work benefits as well as a tightening of eligibility for sickness and disability benefits, would minimize disincentives for labor force participation (Carcillo and Grubb, 2006). These policies will be all the more important in the context of declining labor supply due to ageing populations.

Figure 5.
Figure 5.

Generosity of Long-Term Unemployment Benefits

(In percent)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Source: OECD (2009b).Note: Unweighted averages, for earnings levels of 67 percent and 100 percent of average wage and four family types. Includes cash incomes, income taxes and social security contributions. Excludes social assistance or housing related benefits. For further details seewww.oecd.org/els/social/workincentives.

16. Reversing recent increases in military expenditure could also yield savings. Reducing outlays in the advanced economies to pre-crisis levels could generate savings of about ½ percent of GDP (Figure 6). Returning spending to levels prevailing roughly a decade ago would yield 1 percent of GDP.

Figure 6.
Figure 6.

Military Expenditure in Advanced Economies, 1990–2010

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: Stockholm International Peace Research Institute (SIPRI) military expenditure database; and WEO.

17. Sizable savings are possible in spending on subsidies. Subsidies averaged about 1 percent of GDP in 2007 in OECD countries, and equaled or exceeded 2 percent of GDP in Austria, Belgium, Denmark, and Switzerland. This spending, including for agricultural subsidies—which are large in some countries—should be reexamined and replaced, where possible, with more targeted instruments to provide income support. In particular, priority should be given to phasing out energy subsidies, including for petroleum products. Tax-inclusive subsidies for these products, which also incorporate estimates of the needed taxation to offset externalities, are projected to reach 1 percent of global GDP in 2010 (Coady and others, 2010) (see also below). Advanced economies account for about a quarter of this total, and emerging countries over half.

18. Public spending on climate change is expected to increase, but this can be moderated by improving the efficiency of these outlays.10 Subsidies for renewable electricity and biofuels may have become excessive.11 Potentially more productive spending to address climate change includes programs for energy R&D and low-carbon or climate-resilient infrastructure. While additional expenditures (in some cases substantial) are needed to address climate concerns in advanced and emerging countries, the primary focus of climate policies should be to reduce emissions through the appropriate carbon pricing (see below). Even beyond countries’ domestic climate policies, increased public expenditures from advanced countries will be needed to help meet commitments to support adaptation and mitigation in developing countries (pledged to reach $100 billion by 2020).

19. Expenditure reviews could help guide the design of country-specific strategies. These reviews, which have played a key role in expenditure reform in several advanced economies, can provide valuable input to guide long-term reform by addressing fundamental questions on the role of government and the cost effectiveness of different policy interventions (IMF, 2008b; and Kelly, 2007). These reviews should also identify expenditure inefficiencies and be integrated with performance-based budgeting.

20. Coordination with subnational government will be crucial for ensuring successful expenditure reform. Subnational governments often account for a sizeable share of the adjustment during successful fiscal consolidations (Darby, Muscatelli, and Roy, 2004; and Kumar, Leigh, and Plekhanov, 2007). Clarifying expenditure responsibilities and revenue assignments has helped strengthen budget constraints on local governments, while negotiation of binding fiscal targets has helped to coordinate policies across the different tiers of government. Use of cooperative arrangements between different levels of government also helps increase ownership of shared economic and fiscal objectives (IMF, 2009).

D. Age-Related Spending

21. Significant challenges lie ahead in dealing with age-related spending, especially health care. Public expenditure on pensions is projected to rise by 1 percentage point of GDP between 2010 and 2030 in the advanced economies. The relatively modest increase in this spending—in spite of the ageing of the population—reflects the significant reforms that have already been made in many countries. A further deepening of these reforms could place public pension spending on a sustainable path. In health, in contrast, the outlook is more challenging. Staff projects an increase in spending of about 3½ percentage points of GDP over the next 20 years. Containing the growth of public expenditures on health care will thus need to figure prominently in fiscal consolidation strategies over the next several years.

Pension systems

22. Staff projects that pension spending will increase by an average of 1 percentage point of GDP over the next 20 years (Appendix III and Figure 7). Large increases in pension expenditures are projected in advanced countries that have not substantially reformed their traditional pay-as-you-go systems (especially in Belgium, Greece, and Luxembourg). In other advanced economies, the increase in pension expenditures would be less marked due to the projected impact of already legislated reforms in offsetting the demographic pressures (Appendices IV and V).12 Adjustment needs may well be larger, though, as the projections assume that these reforms will not be reversed, even when they involve large cuts in replacement rates (as in Italy and Japan). Among the emerging economies, those with relatively high spending in 2010 are projected to experience the steepest increase in pension expenditures (especially Russia and Ukraine) over the next twenty years. In several other emerging countries, where coverage is currently low, the projected increase in expenditures is much less severe (China, India, and Pakistan).13 Beyond 2030, emerging economies are expected to experience a faster pace of ageing compared to the advanced economies.

Figure 7.
Figure 7.

Change in Public Pension Expenditures, 2010–30

(In percent of GDP)

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Sources: Country authorities; EC (2009); OECD (2009); ILO (2010); and IMF staff estimates.

23. The cumulative fiscal cost of future pension spending increases is large (Table 4). Over the next 20 years, the net present value (NPV) of pension spending increases is about 8½ percent of GDP for advanced economies and 8 percent of GDP for emerging countries. The fiscal cost of pension increases over the subsequent twenty years is even larger—over 20 percent of GDP for both advanced countries and emerging economies.14

Table 4.

Net Present Value of Future Pension Spending Increases

(In percent of GDP)

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24. Advanced and emerging economies face different challenges. In countries where coverage is extensive, the share of elderly population is larger, and spending is high—mainly the advanced countries—the primary objective should be to stabilize pension expenditures over the longer term while maintaining a reasonable rate of return on pension contributions and ensuring that pension benefits are adequate to prevent old-age poverty. In contrast, in the emerging economies, which generally have lower expenditures due to younger populations and less extensive coverage, the challenge is to expand pension coverage, but in a manner that does not generate fiscal imbalances as these systems mature.15 For emerging economies with high household savings rates (such as China), increased pension coverage would also support efforts to make domestic demand the primary catalyst of growth (see Baldacci and others, 2010).

25. Three policy options are available to offset the projected increase in spending of 1 percentage point of GDP between 2010 and 2030.16 Figure 8 illustrates the tradeoffs across the typical options available to offset increases in pension spending—raising the statutory retirement age, reducing benefits, or increasing contribution rates. A two-year increase in the statutory retirement age would be sufficient to stabilize pension spending as a share of GDP at its 2010 level over the next two decades. This two-year increase in statutory retirement ages is roughly equivalent to a cut in benefits of 15 percent (corners of black solid line) and delivers similar fiscal effects as a 2 percentage-point increase in payroll taxes (origin).17

Figure 8.

Illustration of Policy Options to Offset a Pension Spending Increase of 1 Percentage Point of GDP

Citation: Policy Papers 2010, 044; 10.5089/9781498337359.007.A001

Source: IMF staff estimates.

26. Raising statutory retirement ages should be the starting point for reform. Raising retirement ages would have a powerful effect: a one-year increase in the statutory age in the advanced countries would offset about half of the increase in spending projected between 2010 and 2030.18 Increases in statutory retirement ages are largely justified by the projected increase in longevity over the next 20 years: between 2010 and 2030, the number of years individuals are expected to live beyond the statutory retirement age is projected to increase by an average of 2 years in emerging and advanced countries (Table 5). Increases in the statutory retirement age should be accompanied by steps to limit the generosity of early retirement programs, which allow individuals to claim pensions, on average, by about 4 years earlier than the statutory age. It will also be important to tighten eligibility for disability pensions.

Table 5.

Statutory Retirement Ages and Years in Retirement

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Source: IMF staff estimates.Notes: Legislated and planned increases in statutory retirement ages are included in the calculations for 2030. See Appendix Table 18 for figures by country.

27. Raising the statutory retirement age, however, may not be sufficient in some countries to offset the projected increases in pension spending. The remainder of the increase in expenditures could be addressed with a combination of benefit reductions and increases in contributions.

  • Reduce benefits. Many advanced countries have already moved in this direction—in Japan, Korea, and Sweden, benefit cuts of nearly 20 percent or more are set to occur within the next 20 years (Table 6). Benefits could be reduced by modifying the base used to calculate benefits, modifying indexation rules, or taxing pensions.19 Cuts in pensions, however, should preserve benefits that are sufficient to lift the elderly out of poverty. Consideration should also be given to rules that link benefits and contributions to demographic and economic variables to maintain actuarial balance.20 Additionally, economies looking to expand coverage while containing the growth of expenditures might consider means testing of pensions (as in Australia and, to some degree, Canada).21 Means testing, however, could weaken the link between contributions and benefits, hampering efforts to increase compliance and expand coverage.

  • Increase contributions. Changes in rates of social contributions need to be assessed together with potential changes in the rate of personal tax on labor income (discussed in Section III), since it is their combination that determines the effective marginal and average tax rates likely to affect labor participation and hours worked decisions.22 Taxes on earnings are already high in a number of countries (in Austria, Belgium, France, Germany, Hungary, and Italy, the tax wedge is already near or above 50 percent of total labor costs). Other countries may have room for raising payroll contribution rates (Australia, Iceland, Ireland, Japan, Korea, New Zealand, and the United States have a tax wedge at or below 30 percent), and in some cases it may be appropriate to lift the ceiling on earnings subject to contributions. The incentive effects of social contributions, however, might be less marked if their payment is seen (correctly or not) as implying increased benefit entitlement.

Table 6.

Tax Wedge and Replacement Rates

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Sources: OECD (2009a); and IMF staff estimates.