Fiscal Policy and Long-Term Growth

This paper explores how fiscal policy can affect medium- to long-term growth.

Abstract

This paper explores how fiscal policy can affect medium- to long-term growth.

Introduction

1. Fiscal policy can play an important role in supporting strong, lasting and equitable growth. In the aftermath of the global financial crisis, potential output in many affected countries declined sharply. Restoring robust growth is essential for addressing the fiscal challenges ahead. Fiscal policy can make an important contribution to lifting potential growth. At the macro level, fiscal policy helps ensure macroeconomic stability, an essential prerequisite for growth; at the micro level, tax and expenditure policies can boost growth by altering work and investment incentives, promoting human capital accumulation, and enhancing total factor productivity. Consistent with earlier studies, fiscal policy is defined to encompass overall budget balance, tax, and expenditure policies (Cottarelli and Keen, 2012; Tanzi and Zee, 1997).

2. Endogenous growth theory provides the analytical framework for studying the effects of fiscal policy on long-run growth. In contrast to neoclassical growth theory, in which policy can only have a transitory effect on growth since long-term growth is driven by exogenous and policy-invariant factors, endogenous growth theory provides a framework to analyze how government policy can affect long-term growth, making it the framework of choice in the public finance literature (Barro and Sala-i-Martin, 1992; Rebelo, 1991). In practice, however, it is difficult to distinguish between permanent and transitory, but persistent, effects on growth.

3. This paper draws on the Fund’s expertise in providing hands-on advice on fiscal reforms, complemented by a multi-pronged analysis. The Fund has significant expertise and a unique perspective on structural fiscal reforms, including through its extensive technical assistance program.1 The paper also draws from an extensive review of the literature on the topic and several analytical studies. First, the paper presents 9 country studies covering advanced, emerging market, and low-income countries (LICs), spanning 12 reform episodes.2 The analysis uses a novel technique to estimate the post-reform impact on medium- to long-term growth, which is proxied by 10-year average growth rates following reforms. Second, a statistical analysis identifies the share of fiscal reform episodes that are followed by growth accelerations within the next 5 years. Finally, an endogenous growth model simulates the growth impact of several revenue and spending reforms. However, fiscal policy is only one amongst many factors that drive growth. Despite attempts at isolating the effect of fiscal policy by using three complementary analytical techniques, the results should be interpreted with care given the difficulty in disentangling the impact of fiscal reforms from other factors.

4. The paper differs in important ways from other studies. First, the coverage in terms of both regions and policies is wider than in other studies where the focus is on a particular country group or region (e.g., Abdon and others, 2014; and IDB, forthcoming) or on specific issues such as the design of tax structures that support growth (OECD, 2010a), and the long-term growth effects of public spending (Barbiero and Cournède, 2013). Second, the discussion of policy measures is organized around the main growth channels rather than by policy instrument as is common in the literature. Third, the paper explicitly looks into the equity implications of fiscal policy reforms, an issue that has received less attention in the literature. Finally, all country studies use a consistent analytical framework to assess the impact of fiscal reforms on potential growth.

5. The growth dividend from fiscal reforms could be substantial. The country studies suggest that there are significant potential gains from fiscal reforms. In advanced countries, per capita growth is estimated at about ¾ percentage points higher following fiscal reforms. The growth dividend could be even higher in emerging markets and LICs. As mentioned above, these results should be interpreted with caution. Other coterminous reforms also played an important role in many cases, and the available analytical tools are limited in the degree to which they can disentangle the effects of fiscal policy from other factors. Simulations of an endogenous growth model, which does isolate the impact of fiscal reforms, show that even a budget-neutral tax reform package aimed at enhancing the efficiency of the tax system may lift long-term growth by as much as ½ percentage point. Shifting the composition of spending toward infrastructure investment could add ¼ percentage point. Finally, a statistical analysis shows that there is a relatively high likelihood that fiscal reforms are followed by growth accelerations.

6. The effectiveness of growth-friendly fiscal policy is enhanced when reforms reinforce each other and are accompanied by complementary structural reforms. Combining fiscal reforms (e.g., scaling up infrastructure investment while improving the public investment process) increases their effectiveness. Complementary reforms such as liberalizing trade, labor and product markets can magnify the impact of fiscal reforms by promoting savings, stimulating investment, and unlocking productivity gains.

7. Policy design and social consensus matter for the successful implementation of reforms. Appropriately designed fiscal reform packages can serve both growth and equity objectives. Social consensus enhances the likelihood of reforms being implemented and sustained. A number of strategies can help foster public support for reforms, including effective communication with stakeholders and the inclusion of compensatory measures for those expected to lose from reforms.

8. The paper is organized as follows. Section II draws on existing empirical evidence, country studies and statistical analysis to examine the key channels through which fiscal policy, both at the macro and micro level, influences medium- to long-term growth. Since some reforms may require fiscal space, the paper next discusses how additional resources can be generated with the least adverse impact on growth. The section ends with the implications of fiscal reforms for equity. Section III examines the design of fiscal reforms and political economy considerations. Section IV summarizes policy lessons, and Section V offers issues for discussion.

Fiscal Policy and Long-Term Growth: What Works?

A. Macroeconomic Stability-A Prerequisite for Sustained Growth

Fiscal sustainability and macroeconomic stability are key for medium- to long-term growth. Policy uncertainty and high levels of public debt deter private investment and slow growth. Fiscal consolidation can help, but its impact on growth depends notably on its pace, composition and financing modalities. In many advanced and emerging economies, ensuring fiscal sustainability would require addressing age-related spending pressures without harming equity. In contrast, many LICs with low debt levels and strong growth prospects may have scope for additional productive spending.

9. Macroeconomic stability is an essential prerequisite for strong and lasting growth. Large fiscal deficits reduce aggregate savings in the economy and may lead to inflation, high interest rates, and balance of payments pressures, with negative growth consequences.3 Indeed, policy uncertainty created by macroeconomic instability affects growth through the volatility of returns on investment and misallocation of resources as price signals become distorted (Fischer, 1993; and Fatas and Mihov, 2013). This underscores the role of automatic stabilizers in reducing macroeconomic volatility: fiscal frameworks that facilitate the symmetric functioning of automatic stabilizers eliminate an important source of public debt accumulation and foster medium-term growth (IMF, 2015a).The potential growth dividends from fiscal stabilization are especially large in advanced economies where an increase in the responsiveness of fiscal policy to output by one standard deviation could boost annual growth by about 0.3 percentage point. Dividends appear much smaller in emerging markets and LICs, where fiscal stabilization is less effective and is dominated by developmental priorities (IMF, 2015a; Aghion and others, 2014).

  • Fiscal deficit reductions featured prominently in many country studies (Figure 1). In Chile, macroeconomic stability was pursued before growth took off. Notably, large cuts in spending and measures to broaden the tax base resulted in an improvement of the primary balance by about 28 percentage points of GDP over five years in the 1970s. After an initial decline, GDP growth picked up markedly and Chile’s growth performance became one of the strongest in Latin America.

Figure 1.
Figure 1.

Fiscal Deficits Post-Reform 1/

(Index, reform period t = 100)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations; Supplement 1.1/ Chile refers to 1975–1980; Germany to 2004–2008.

10. In developing economies, the relationship between fiscal deficits and growth is likely to be non-linear and dependent on financing modalities.4 In contrast to many advanced countries, developing countries tend to have lower debt levels, strong growth prospects, high population growth, and large infrastructure gaps. Empirical evidence suggests that the relationship between fiscal adjustment and growth depends on the level of the fiscal deficit. For example, Adam and Bevan (2013) estimate that for developing economies the long-term growth dividend of cutting the deficit disappears or reverses below a threshold of around 1½ percent of GDP. In addition, the magnitude of the dividend depends on how the deficit is financed: Gupta and others (2005) find that reductions in the deficit that translate into significant cuts in domestic financing tend to be associated with higher growth rates. In Uganda public financial management reforms, including strict expenditure controls, facilitated a reduction in budget deficits and their monetization, which helped lower inflation. Greater macroeconomic stability in turn paved the way for higher growth.

11. High public debt tends to hamper growth by increasing uncertainty over future taxation, crowding out private investment, and weakening a country’s resilience to shocks (Krugman, 1988). Figure 2 illustrates the link between debt and growth: at one-year horizons, high debt levels are associated with lower growth; over longer horizons, the relation is less pronounced, but a tradeoff still remains. However, it is rather difficult to ascertain the level of public debt that is prudent to sustain, or for how long it can rise without jeopardizing macroeconomic stability. Empirical evidence suggests that the level at which the debt-to-GDP ratio starts to harm long-run growth is likely to vary with the level of economic development and to depend on other factors, such as the investor base.5

Figure 2.
Figure 2.

Debt and Growth: Short- and Long-Term Horizons

(Percent)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: Pescatori, Sandri and Simon (2014).

12. The pace of fiscal consolidation is important for medium- to long-term growth. A vast literature, largely from the pre-crisis period, emphasizes the scope for expansionary fiscal adjustments—not only for advanced economies, but also for emerging market economies and low-income countries.6 However, in a deep and lasting recession, fiscal consolidation is likely to have a negative short-term impact on growth when there are large negative output gaps and monetary policy is constrained by the zero lower bound and/or inoperative credit channels. In such an environment, consolidation policies can be harmful to longer-term growth due to possible hysteresis effects, whereby temporary layoffs become permanent (De Long and Summers, 2012). Furthermore, in a deep recession, investment is likely to remain low for a prolonged period of time, reducing further potential output. Overall, these arguments highlight the need to carefully calibrate the pace of fiscal adjustment during a deep recession. In particular, countries that are not under market pressure should proceed with gradual fiscal consolidation, anchored in a credible medium-term plan (Blanchard and Cottarelli, 2010; IMF, 2013b; Jaramillo and Cottarelli, 2013).

13. The composition of adjustment matters as well. The appropriate mix of revenue and expenditure measures depends on each country’s specific conditions. Policymakers need to consider the durability of the selected measures and their impact on growth and equity. For advanced economies, expenditure-based fiscal consolidations have been shown to be more durable (Alesina and Ardagna, 2012), and have been associated with growth in private investment (Alesina and others, 2002). In contrast, for LICs Baldacci and others (2004) find that revenue-based adjustment leads to more durable consolidation episodes, with greater benefits for growth. In addition, credit-constraints matter: in the presence of high private debt and credit supply restrictions, deficit reductions achieved through tax-base broadening while protecting public investment are supportive of medium-term growth in both advanced and emerging economies (Baldacci, Gupta, and Mulas-Granados, 2015). Large expenditure-based consolidations tend to increase inequality, which can undermine long-term growth (Ball and others, 2013; Woo and others, 2013; Berg and Ostry, 2011). Some degree of pragmatism is therefore needed to strike the proper balance between revenue and spending measures.7

  • Faced with sluggish growth and high fiscal deficits (10 percent of GDP in 1986), Malaysia cut current spending and rationalized inefficient public investment. As a result, the budget registered small surpluses and deficits during the 1990s, the private investment-to-GDP ratio more than doubled, and annual growth averaged around 8 percent. Similarly, in the Netherlands, an expenditure cut of 15 percent of GDP between 1982 and 2000 created room for lower taxes and helped pave the way for private investment and private sector job-creation. At the same time, both countries managed to avert adverse consequences on income inequality (as further discussed in Section D on Growth and Equity).

14. Ensuring fiscal sustainability in a number of countries will require putting pension and health systems on a sound financial footing. In advanced and emerging market economies, age-related spending on public pensions and health care accounts for a large share of government spending (40 percent and 30 percent, respectively; IMF, 2014f). As populations age, these spending pressures can undermine long-term fiscal sustainability—and any fiscal consolidation strategy needs to include reforms in these areas (Blanchard and Cottarelli, 2010). Several countries studied strengthened long-term fiscal sustainability by reforming their pension and health systems. For instance, Poland shifted from a financially unsustainable defined-benefit system to an actuarially solvent defined-contribution system; and Germany put its pension system on a more sound financial footing by linking pension benefits to the old-age dependency ratio, tightening access to early retirement and raising the statutory retirement age. In health care, Germany and the Netherlands introduced a combination of macro- and micro-level reforms to contain cost and enhance efficiency, including price controls on pharmaceuticals, higher co-payments and contributions, and budget caps.

15. Strong and transparent institutions support macroeconomic stability and the sustainability of fiscal policies. Because debt and deficits have an impact on longer-term growth, fiscal frameworks and institutions that help mitigate deficit and debt biases can help promote growth. Countries with stronger budget institutions tend to deliver a more growth-friendly fiscal adjustment (IMF, 2014g).8

B. How Can Fiscal Structural Reforms Promote Growth?

In theory, fiscal reforms can affect growth through four main transmission channels—labor supply, investment in physical and human capital, and total factor productivity. Country studies and statistical analysis find some evidence of higher growth following the implementation of growth-friendly fiscal reforms, with some variation in the relative importance of channels and fiscal policy areas across country groups.

16. There are four main channels through which tax and expenditure policy reforms can impact medium- to long-term growth:

  • Labor supply. The tax-benefit system (including labor income tax and social transfers) influences decisions on whether to participate in the labor market (extensive response) and how much to work (intensive response). Empirical evidence suggests that this transmission mechanism is particularly important at the lower end of the income distribution and for specific groups, such as women and older workers (IMF, 2014a; OECD, 2011). Reforms in labor taxes and/or benefits were undertaken in five of the nine country studies (Australia, Chile, Germany, Ireland, and the Netherlands). Devereux and Love (1994) and Turnovsky (2000) use endogenous growth models to show how fiscal policy through labor tax cuts can lift long-term growth by inducing a positive labor supply response.

  • Physical capital. Taxation of capital income influences private savings and investment decisions. At the individual level, capital income taxes reduce the return on savings. At the corporate level, profit taxes reduce the rate of return on investment projects, while different tax treatment of financing (i.e., deducibility of interest expenses) creates a bias toward debt financing. This bias leads to inefficiently high debt-equity ratios and discriminates against innovative firms (De Mooij, 2011). On the expenditure side, efficient public investments can boost returns on private investment and thereby enhance long-run growth. All countries studied implemented investment-friendly tax reforms and/or bolstered public capital spending. The models of Rebelo (1991) and Devereux and Love (1994) illustrate how capital tax cuts encourage investment and boost long-term growth.

  • Human capital. Human capital is one of the main drivers of long-term growth (Lucas, 1988; Barro, 2001). In endogenous growth models, human capital contributes to growth directly as an input in production activities, and indirectly by promoting technical progress with positive externalities. Both tax and spending policies can help raise the human capital stock, given the presence of positive externalities and credit market imperfections. Investment in health and education constituted an important part of the fiscal reform packages in three country studies (Ireland, Tanzania, and Uganda). Pecorino (1993), and King and Rebelo (1990) use endogenous growth models to show how income tax reductions can encourage human capital accumulation and hence growth by increasing the returns to education.

  • Total factor productivity. One important channel to enhance productivity is through technological progress. There is a strong case for government intervention in the presence of positive externalities from research and development (R&D). Governments can either spend on R&D directly or (more commonly) provide tax incentives to encourage private R&D spending. If designed and implemented well, these can yield high social returns. In addition, as noted above, public infrastructure and services can have a direct effect on private sector productivity and promote technological progress; and public spending on education can help foster a better absorption of new technologies. In six country studies either tax incentives for R&D activities were provided or public R&D spending increased noticeably (Australia, Germany, Ireland, Malaysia, the Netherlands, and Poland). Public infrastructure to support private sector activity improved substantially in Chile, Malaysia, and Poland. Baier and Glomm (2001), and de Hek (2006) present endogenous growth models where public investment increases total factor productivity and ultimately long-term growth.

17. Country studies reflect the potential of fiscal reforms to affect growth through these channels (Figure 3; and SM/15/92, Supplement 1 ). Using the Synthetic Control Method (SCM), country studies show a significant increase in average growth during the 10 years following fiscal reform episodes, compared with the counterfactual (Figure 3a). However, the limitations of the SCM suggest interpreting the results with care (Box 1). While biases may run in both directions, one should be particularly cautious in attributing the increase in growth entirely to fiscal reforms, as they were often part of broader reform packages (e.g., reforms of labor and product markets) that also played an important role. With this caveat, the country studies find that:

  • In advanced countries, excluding Ireland which experienced a significantly higher growth dividend, per capita growth in the post-reform period is about ¾ percentage points higher than the counterfactual. In developing economies, the estimated divergence in growth paths reaches almost 2½ percentage points, on average.

  • Relative contributions of capital, labor, and total factor productivity (TFP) to total growth showed different patterns across income groups: while advanced economies experienced relatively balanced contributions, in emerging markets and LICs capital accumulation was the dominant growth driver (Figure 3b).

  • Shifts in the contribution of capital, labor, and TFP to growth at times coincided with the focus of fiscal reform efforts: for example, in cases where an overhaul of labor taxation and reductions in the tax wedge were at the core of tax changes (e.g., Ireland, the Netherlands), the contribution of labor in total output growth increased after the reform.

Figure 3.
Figure 3.

Evidence from Country Studies: Growth Post-Reform

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations; Supplement 1.1/ 5-year averages for Germany and Poland.2/ Chile (1) refers to the first reform episode (1974); Chile (2) to the second reform episode (1983); Australia (1) to the first reform episode (1985); and Australia (2) to the second reform episode (1998).

18. Fiscal reforms are frequently followed by growth accelerations (Annex I; Figure 4). Analysis of 146 episodes of growth accelerations in 112 countries shows that revenue reforms are most likely to be followed by a growth acceleration (defined as a durable increase in five-year average growth of at least one percentage point) in emerging market economies, while expenditure reforms displayed the most potential in both advanced and emerging economies (Figures 4a and 4b).

  • On the revenue side, 37 percent of episodes involving reductions in the share of income taxation matched by an increase in the share of indirect taxation are followed by a growth acceleration in the sample as a whole (Figure 4c). This is consistent with the findings of recent empirical studies (see for instance, Arnold and others, 2011).

  • On the expenditure side, increases in health, education and infrastructure spending are followed by higher growth in 20 to 40 percent of all identified cases.

  • Combined revenue and expenditure fiscal reform packages have a higher likelihood (around 60 percent of reform cases) of being followed by growth acceleration.

19. Model simulations show that even budget-neutral fiscal reforms can yield a significant growth dividend. A budget-neutral tax reform package aimed at enhancing the efficiency of the tax system may lift long-term growth by about ½ percentage point. Shifting the composition of spending toward infrastructure investment could add ¼ percentage point.

Figure 4.
Figure 4.

Growth Accelerations

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations.Note: Reported are the ratios of fiscal reforms followed by a growth accelerations within a 5-year period to the total number of fiscal reforms (in percent). Panels A and B show the range between 10th and 90th percentiles across different types of revenue and expenditure reforms. The red dots indicate averages.

The Synthetic Control Method

The Synthetic Control Method (SCM) is a formal data-driven procedure to quantify the effect of an event (fiscal reform in this study) on an outcome variable of interest (i.e., medium- to long-term growth, defined as 10-year average growth rates). It is particularly well-suited for comparative case studies since it removes discretion in the selection of comparison groups. The method is based on the creation of an artificial counterfactual (i.e., growth performance in the absence of fiscal reform) using data prior to the event and then comparing the outcomes for the counterfactual and the unit being analyzed (the country that implemented fiscal reforms in this case) after the event has occurred.

The counterfactual or the synthetic unit is constructed as a weighted average of countries that have similar characteristics as the case study but are unaffected by the event. Country weights are chosen to minimize the distance between the case study country and its counterfactual in terms of the outcome variable and its predictors (Abadie and others, 2010). In general, only a few comparator countries receive positive weights.

The effect of an event is obtained as the difference between the outcome variable for the country in question and the weighted average of the outcome variable for the synthetic control group. Robustness of the results is checked using placebo tests where, for example, the time of occurrence of the event is shifted backward or forward, or countries in the synthetic group are replaced with other countries which are unaffected by the event.

The presence of two potential biases suggests interpreting the results with caution, however. First, the impact of fiscal reforms could be overstated, as it is difficult to disentangle their growth impact from that of various other factors affecting growth. Although various tests are used to check the robustness of the results, the difference between post-reform growth in the country of interest and its synthetic counterpart could be due to factors other than fiscal policy. On the other hand, results could be potentially biased downwards if the comparator groups include countries that also underwent growth-enhancing reforms.

Policies to Encourage Labor Supply

In many advanced and emerging economies, sustaining high growth will require offsetting the adverse impact of aging on labor supply and addressing low labor force participation rates, in particular of women. This can be done by cutting taxes on labor, redesigning social benefits, and strengthening active labor market programs (ALMPs). In low-income countries, the focus should be on providing equal access to education and dismantling legal obstacles to female labor force participation (FLFP).

20. Lowering overall taxes on labor income can boost labor supply. The overall labor supply response to cuts in labor tax depends on the elasticity of labor supply and on the degree of competition in the factor and product markets. Reducing the tax wedge can help address the problem with youth unemployment, which has increased sharply in Europe since the crisis (Banerji and others, 2014). Figure 5 shows that, in advanced economies, the labor tax wedge—including social security contributions—is negatively correlated with employment, while in developing economies there is no clear relationship, mainly due to smaller social safety nets and the narrower revenue base of personal income tax (IMF, 2014a).

  • Revenue-neutral policy simulations using an endogenous growth model show that reducing tax on labor income by 5 percentage points leads to higher long-run economic growth of about 0.2–0.3 percentage point, as the increase in the after-tax wage induces higher labor supply.

  • Country studies show that labor tax cuts were used to boost labor participation, including in Ireland and the Netherlands. For instance, in Ireland labor taxes were cut substantially in the context of a social partnership agreement. This contributed to a strong increase in labor force participation and a noticeably higher contribution of labor to total economic growth.

Figure 5.
Figure 5.

Relationship Between the Tax Wedge and Employment Rate

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF (2014a).Note: the black lines shows an ordinary least squares (OLS) regression line.

21. Unemployment benefits can be designed to strengthen incentives to seek employment without compromising their important contribution to the social safety net. Unemployment benefits play a key role in advanced economies in protecting individuals from loss of income due to transitory or structural unemployment. However, these programs, if not well designed, can adversely affect employment incentives and outcomes (Meyer, 2002; Abbring and others, 2005; OECD, 2006). The withdrawal of benefits as individuals return to employment can operate like a tax on earned income and create work disincentives, especially for low-wage workers and families with children. Efficient benefit design can help, including through the following design features:

  • Eligibility criteria. Conditioning eligibility rules (e.g., on previous contributions or participation in ALMPs) can better support and incentivize the return to employment. For instance, in the Netherlands, almost one-fifth of the working-age population received unemployment or disability benefits prior to reforms in the mid-1980s that tightened access and resulted in an increase in participation (Watson and others, 1999).

  • Benefit duration. Lowering the maximum duration of benefit eligibility can expedite the return to employment. About a third of OECD countries have a maximum duration in excess of 12 months. Reducing replacement rates during the course of unemployment spells can enhance work incentives more gradually. The desired generosity of benefits can be achieved through various combinations of benefit levels and duration.

  • Individual unemployment savings accounts (ISAs). Increased use of these accounts could help reduce the distortionary impact of contributions by strengthening the link with benefits received and facilitate the expansion of unemployment insurance schemes in developing economies with large informal sectors. Under this system, part of the unemployment insurance contribution could be credited to an individual account on which a person receives interest (Bovenberg and others, 2012). During unemployed periods, individuals can draw money from their account, and once the account is exhausted, they can borrow from the government at the same interest rate. Individual accounts are used in a number of emerging economies, including Brazil and Chile (Hijzen and Venn, 2011).

22. In particular, advanced economies could intensify the use of ALMPs and in-work benefits to reduce unemployment. Reforms to replace “passive” benefits which dilute incentives to return to employment with ALMPs and in-work benefits have contributed to a decline in unemployment in a number of advanced countries:

  • Conditioning of means-tested transfers on participation in ALMPs. In most advanced economies, continued eligibility for benefits is conditioned on participation in ALMPs, including personal employment services, training, job placement, and public employment schemes. Tight activation measures are especially important for helping job-seekers and providing incentives to work. The intensity of activation requirements should increase with unemployment duration to allow an initial period for job search, followed by assistance with job placement and access to individually tailored training opportunities—which are especially important for youth unemployment and the long-term unemployed. Although the use of ALMPs has increased over the last decade, there is still significant room for improvement in many countries (OECD, 2012b). Germany introduced activation conditions, complemented by wide-ranging labor market reforms, including improving job search efficiency, raising work incentives, and fostering labor demand (Hüfner and Klein, 2012). As a result of these reform packages, between 2000 and 2013, labor force participation increased from 66 percent to 74 percent, and the unemployment rate fell to 5.2 percent in 2013, after reaching a peak of 11.2 percent in 2005 (OECD, 2014c).

  • Greater use of in-work benefits. Many economies that target labor market participation (Germany, the Netherlands, and Sweden) have adopted a system of in-work benefits that allows for the gradual withdrawal of benefits as earnings or employment duration increase (IMF, 2012). This reduces the net tax on additional earnings; even turning it negative for low-income groups, with significant benefits for employment, equity, and poverty reduction.

23. Targeted tax and spending measures for specific groups could elicit an even greater labor supply response with a positive impact on growth.9 In many countries, labor force participation of women and older workers is still low. For instance, the gender gap in labor force participation rates remains high in most regions, ranging from 51 percentage points in the Middle East and North Africa to 35 percentage points in South Asia and Central America and to 12 percentage points in OECD countries (Elborgh-Woytek and others, 2013; Cuberes and Teigner, 2014). Key obstacles vary across income groups: for instance, in developing economies access to education, legal obstacles and poor infrastructure are more critical for FLFP than e.g. parental leave policies (Das and others, 2015; Gonzalez and others, 2015). At the same time, most countries have witnessed declining old-age employment despite higher life expectancy. Targeted measures can help boost women, older workers’ and low-skilled workers’ supply response:

  • Women: Female labor supply is more responsive to taxes than male labor supply. Hence, tax relief for women could elicit a positive net response, even when financed by higher taxes on men. For instance, India makes a gender distinction by applying a higher tax exemption for women, and most advanced economies replaced family taxation with individual taxation to reduce the tax burden for secondary earners (often women). Special tax relief could also be targeted at single parents. On the expenditure side, interventions that could be critical in increasing FLFP include closing the gender gap in education (e.g., India, Turkey); well-designed family benefits, including paid parental leave up to about two years (e.g. the United States); more flexible work options (e.g., India and Japan); and greater availability of child-care options (e.g., Germany, Japan, and the United States).10 Policies that have had a beneficial impact on FLFP include social benefit reforms (Germany, and the Netherlands); higher labor market flexibility (Germany, and the Netherlands); better education (Ireland); and a shift from family to individual taxation (Ireland).

  • Older workers: Older workers are more sensitive to financial incentives than younger workers (Blundell, 2014; IMF, 2014a). Lower tax rates (including implicit taxes on continuing work) can increase incentives to remain in the labor force. Australia, Denmark, the Netherlands, and Sweden, for example, have introduced specific earning tax credits for older workers, aimed at stimulating labor-market participation. On the expenditure side, pension reform could also boost the labor supply of older workers. Options include increasing the effective retirement age, and adjusting pension benefits to actuarially fair levels that do not distort participation decisions. For instance, future pension benefits could be adjusted fully for extra years of contributions, eliminating incentives to retire early. Many advanced and emerging countries enacted legislation to raise statutory retirement ages (including Australia, France, Germany, and Poland). For example, participation of older cohorts increased significantly in Germany after it phased out early retirement options (Figure 6). At the same time, targeted measures should protect against old-age poverty, including the expansion of social pension for low-income workers, financed through general revenues rather than labor taxes (e.g., India, Indonesia, and Thailand; Clements, Eich, and Gupta, 2014).

  • Low-skilled workers: Empirical evidence shows that targeted tax credits result in positive net employment effects as low-skilled workers exhibit higher labor supply elasticities than high-skilled workers (OECD, 2011; IMF, 2014a). Most advanced economies have introduced such in-work tax credits. More progressive tax schedules could also be a revenue-neutral way of reducing tax wedges for low-skilled workers (OECD, 2011; Imervoll and Pearson, 2009; Chirinko and Wilson, 2009). Hiring subsidies or targeted reductions in non-wage labor costs (such as social contributions) can stimulate demand for low-skilled labor.

Figure 6.
Figure 6.

Germany: Change in Employment Rate by Age Group, 2000–2013

(Percent)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: ILO.

Policies to Enhance Investment in Physical Capital

Physical investment—both public and private—is an important driver of growth in all economies and also holds the key to improvements in productivity. This section focuses on the tax policy drivers of private capital accumulation and discusses the importance of efficient public capital investment for the economy’s growth potential.

24. Taxation of capital income influences private savings and investment decisions. By increasing the user cost of capital, corporate taxes can have an adverse impact on domestic investment and FDI (Abbas and Klemm, 2012; Vartia, 2008; Schwellnus and Arnold, 2008). Revenue-neutral policy simulations using the endogenous growth model indicate that reducing tax on capital income by 5 percentage points (while increasing the consumption tax to keep fiscal revenue unchanged) adds about 0.2 percentage point to long-run economic growth.11 Malaysia streamlined and reduced corporate income tax (CIT) to a level comparable to other South-East Asian countries, which contributed to a surge in investment. Similar responses were observed in Germany, Ireland, the Netherlands, and Uganda. In these countries, tax changes were carried out following macroeconomic stabilizations which created the necessary supportive environment for investment (Figure 7).

Figure 7.
Figure 7.

Corporate Income Taxes and Investment Post-Reform

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: Haver, IMF staff calculations, WDI, and WEO.1/ Germany refers to 2004–2008.

25. Reforming corporate income taxes to tax “excess returns” could have a significant growth dividend. While their distortionary impact is widely acknowledged, CITs are an important source of revenue in many economies. Limiting the tax to “excess returns” or rents would reduce investment distortions, thereby promoting long-term growth while still generating revenue (Cottarelli and Keen, 2012). Under the allowance for corporate equity (ACE) scheme, investments that earn a “normal” return are exempt from taxation through a deduction of an imputed return on equity.12 The ACE also reduces the bias toward debt-financing, created by the deductibility of interest expenses (Klemm, 2006; Mirrlees and others, 2011). Several advanced and emerging economies (including Austria, Belgium, Brazil, Croatia, and Italy), have used variants of this scheme. There is evidence that the ACE has had a positive impact on private investment in Belgium (Aus dem Moore, 2014).

26. Tax incentives can significantly erode the revenue base without achieving offsetting benefits from increased investment, unless they are properly designed and limited. Tax incentives take several forms, such as tax holidays, preferential tax treatments in special zones or targeted allowances for certain investments (Figure 8). The choice of incentive, and the design details, matter critically for the effectiveness of tax incentives (IMF, World Bank, OECD, and UN, forthcoming). Well-targeted incentives that directly reduce the cost of capital, such as accelerated depreciation schemes, investment tax credits, and super deductions, have been used with some success in advanced countries (a discussion on incentives for R&D can be found, for example, in the section Policies to Increase Total Factor Productivity). In contrast, open-ended and profit-based tax holidays are less effective and can erode the tax base indefinitely. And they can be very costly: for instance, Cubeddu and others (2008) estimate the cost of CIT incentives in 15 Caribbean countries at around 5½ percent of GDP, on average; and Villela and others (2010) estimate the cost of preferential treatments under the income tax in Latin America to range between ½-6 percentage points of GDP.13 This argues for a rigorous cost-benefit analysis of tax incentives. The investment climate more generally is an important determinant of the level of foreign investment: FDI is eight times stronger for countries with good investment climates (James, 2013). For example, an assessment of tax incentives that were introduced in Malaysia in 1986 concluded that—while they succeeded in stimulating domestic investment—foreign investors were primarily influenced by other factors (including macroeconomic stability and the quality of infrastructure, World Bank, 1991). At the same time, they came at a very high cost (2.2 percent of GDP).14

Figure 8.
Figure 8.

Regional Prevalence of Tax Incentives

(Percent)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: James (2013).

27. Lack of international cooperation can erode tax bases and squeeze fiscal space. National tax policies can generate cross-border spillover effects: for instance, more favorable tax incentives in one country can divert FDI flows from other countries and thereby dampen their growth prospects and erode their tax base. In addition, multinational enterprises (MNEs) may shift profits from a high-tax jurisdiction to a lower-tax one by using accounting tricks, hence exacerbating the problem of base erosion. For example, in low-income countries this can limit significantly the scope for pro-growth public spending and raise difficult trade-offs between the need to raise revenue by limiting tax avoidance by MNEs and encouraging investment (IMF, 2014c). In a world of increasing tax competition, all countries may end up being worse off. To avoid such an adverse outcome, international cooperation is needed, and initiatives such as the OECD/G20 Base Erosion and Profit Shifting project—which aims at protecting tax bases and ensuring predictability—should be encouraged (OECD, 2014a). In view of the difficulty of achieving and enforcing effective cooperation, however, coordination could initially focus on smaller steps, such as promoting transparency by publishing data on tax expenditures arising from tax incentives and country-by-country reporting on transfer prices used to value intra-firm transactions.

28. Public investment, in particular in infrastructure, can raise the economy’s productive capacity and growth potential. There is a positive relationship between public capital and growth, and developing economies with large infrastructure gaps stand to reap high returns from increasing public investment (Romp and de Haan, 2007; Bom and Ligthart, 2010). In the endogenous growth literature, public capital yields a direct permanent growth dividend (Futagami and others, 1993). It has indirect growth effects by increasing the longevity of private capital (Agenor, 2010). Higher infrastructure investment is estimated to raise output by as much as three percent in advanced economies—assuming, however, significant slack and accommodative monetary policies as well as fully efficient public investment (IMF, 2014b). Staff’s growth acceleration exercise finds that among capital spending categories, transportation and communication spending exhibits the highest likelihood of subsequent growth acceleration (20 percent). In Poland, transport infrastructure expansion contributed to higher growth. Malaysia accelerated the provision of infrastructure between 1985 and 1995, more than doubling existing capacity in most sectors (World Bank, 2000). During the same period, annual growth surged to close to 8 percent.

29. The efficiency of public investment helps raise its productivity. Not all public investment creates economically valuable capital (Pritchett, 2000, and Dabla-Norris and others, 2012). In particular, in countries with weak public investment management processes, public investment is unlikely to translate fully into productive capital and growth (Agénor, 2010). On the flip side, potential gains are substantial: Gupta and others (2014) show that the marginal product of capital is particularly high in low-income countries. Hence, productive investment could have a high growth dividend. The average country loses about 30 percent of the value of its public investment to inefficiencies in the investment process (IMF, forthcoming). The economic dividends from closing this “efficiency gap” could be substantial—(IMF, forthcoming) estimates that the most efficient countries get twice the growth dividend from investment compared with the least efficient countries. Improving institutional arrangements for allocating public investment projects is most important for enhancing efficiency. Tanzania carried out improvements in the investment process (medium-term planning and improved project selection and prioritization) before scaling up infrastructure spending. In Malaysia, inefficient projects by state-owned enterprises (SOEs) were dismantled and public investment re-focused on public infrastructure projects vital to private sector development.

Policies to Support Human Capital Development

Human capital accumulation is a key contributor to growth. At the same time, inequities in education and health outcomes persist in advanced and developing economies. This section focuses on public expenditure and tax policies that can improve equitable access to education and health care.

30. Fiscal policies can play an important role in promoting investment in human capital. Because of the positive externalities of education, the private sector alone cannot provide the optimal level of human capital, which supports the case for government intervention in the provision of educational services (Gerson, 1998; Fisher and Keuschnigg, 2002). Allowing for deductibility of education expenses or provision of tax credits can mitigate the adverse impact of progressive income taxation on human capital accumulation (Heckman and Klenow, 1997). Public spending on education can directly affect education outcomes and raise the stock of human capital. Specifically, Baldacci and others (2008) show that spending on education has a significant impact on output growth in developing countries, with two-thirds of the effect being realized within the first five years and the remainder over the following five-year span. Analysis of growth accelerations finds that a sustained increase in the share of education spending is followed by a growth acceleration in about a quarter of reform cases. Tanzania increased education spending significantly, provided assistance to open new schools in less developed regions, and decentralized the management of schools to enhance accountability. These reforms helped boost enrollment rates and spur sustained economic growth. Ireland’s substantial investment in education from the 1960s onwards helped create a skilled workforce, a key factor for FDI inflows after the implementation of comprehensive fiscal and structural reforms in 1987–89.

31. Education reform in both advanced and developing economies should focus on improving access for disadvantaged groups.15 In developing economies, low-income groups and girls have lower access to education (especially upper secondary and tertiary education), resulting in most of the benefits from education spending going to higher income groups. In most developing economies less than 40 percent of spending is reaching the poorest 40 percent of households (Figure 9). In advanced economies, education spending as a whole is progressive, but spending on tertiary education is regressive and significant inequities in education outcomes persist (OECD, 2014d). Inequitable access to education in both developing and advanced economies reduces opportunities and perpetuates inequality across generations, thereby further constraining the economy’s long-term growth. In Ireland, Tanzania, and Uganda, a range of spending reforms focused on improving access to education helped unlock disadvantaged groups’ untapped productive capacity, while enhancing the distributional impact of education spending. Education reform options include:

  • Increasing investment in lower levels of education. In developing economies a relatively large share of the budget is allocated to higher levels of education. Lower income groups often fail to progress to higher levels of education which are disproportionally accessed by higher income groups. This requires improving access to and progression through primary and lower-secondary education, especially for girls.16 Increasing access to early childhood education is required in both advanced and developing economies, especially given the substantial evidence that this has a crucial impact on education performance at higher levels.

  • Improving the efficiency of education spending. Increased spending on education at lower levels should be complemented by efforts to get better results from existing levels of spending. Inefficiencies in spending are substantial, including in developing economies (Gupta and others, 2007; Grigoli, 2014).

  • Increasing cost recovery in tertiary education. Demand for tertiary education has increased rapidly in both advanced and developing economies, and often faster than public financing capabilities. This has resulted in a decline in the quality of instruction in public institutions and a growth in private education institutions (Woodhall, 2007; OECD, 2011b). Since much of the benefit from tertiary education accrues to graduates in the form of higher earnings and other non-monetary benefits, there is a strong case for financing part of the cost from tuition fees. Income-contingent student loans (to be repaid once students start earning salaries) can relieve the financing constraint on higher education and provide insurance against the inability to repay loans due to low future income (Barr, 2012). Higher private financing allows tertiary education to expand without increasing public spending.

  • Targeting conditional cash assistance. Targeting cash assistance to disadvantaged groups, and conditioning this assistance on certain education outcomes, can help to reduce income barriers to education and improve overall educational attainment. Pioneered in the Mexican PROGRESA program in the late 1990s, conditional cash transfer (CCT) strategies are being increasingly used in both advanced and developing economies, including Brazil, Chile, Nicaragua, Peru, the United Kingdom, and the United States. The largest of its kind—Bolsa Familia in Brazil—provides assistance to about 14 million families or about 50 million people, and is credited with reducing inequality and halving extreme poverty since its introduction in 2003 (World Bank, 2013). The United Kingdom introduced means-tested education stipends conditioned on education performance; and New York City provides targeted education and health subsidies (IMF, 2014e). However, CCT programs are administratively demanding and may require complementary reforms, such as investment in quality health and education services, and targeted information campaigns to raise awareness amongst eligible populations (Grosh and others, 2008; Fiszbein and Schady, 2009).

Figure 9.
Figure 9.

Benefit Incidence of Education and Health Public Spending

(Percent of Public Spending Going to Poorest 40 Percent of Households)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: Davoodi, Tiongson, and Asawanuchit (2010); Lustig and others (2011); World Bank

32. Investing in health care also supports human capital accumulation. Healthier individuals are likely to invest more in their own education and health, thereby further fostering labor productivity and human capital accumulation (Aghion and others, 2010). Empirical studies confirm the potential payoffs for growth from investing in health: Jamison and others (2013) estimate that the economic value of increases in life expectancy in developing economies between 2000 and 2011 was equivalent to a 1.8 percent annual increase in GDP. Staffs growth acceleration analysis suggests that amongst all expenditure categories, health spending is most likely to be followed by growth accelerations (40 percent).

33. In advanced economies, maintaining the access of the poor to health care services during periods of expenditure constraint is a priority. Public health care spending accounted for about 17 percent of primary spending in advanced economies or 6 ½ percent of GDP in 2013, and is projected to rise on average by 3 percentage points of GDP between 2015 and 2030 (Clements, Coady, and Gupta, 2012; IMF, 2015a). Health care reforms to curb the growth of spending will be a necessary component of many countries’ fiscal adjustment plans. Some of these reforms could take the form of an increase in cost-sharing with the private sector, for example through increased co-payments or a reduction in the scope of services provided by the public sector. These reforms should be designed to ensure that the poor retain access to services, for instance, by exempting them from co-payments.

34. In developing economies, a focus on universal access to a basic package of health services would yield the highest growth dividends. Fiscally sustainable progress toward universal access can be achieved through the following measures:

  • Expanding health coverage to low-income households. The recent Lancet Commission report (Jamison and others, 2013) emphasizes that a fiscally sustainable, publicly financed, basic health package covering essential health care, would benefit the poor and enhance the progressivity of public health spending. In many developing economies the poor often forgo or delay necessary care at an early stage of illness when treatment is more cost effective. Many households fall into poverty because of high out-of pocket spending or catastrophic illnesses. Access to health care can provide financial protection and free up households from the need to accumulate unproductive precautionary savings.

  • Reducing or eliminating user charges for low-income households. Health services outside the basic package could be financed by a mix of public and private mechanisms, including insurance contributions, fees, and copayments. However, out-of-pocket spending under the typical health insurance plan may still be too high for low-income households. To further improve the affordability of health care, it may be necessary to reduce or eliminate user charges for certain groups or services. In particular, preventive care, such as immunizations, should be offered free of charge given their large social benefits. In addition, linking utilization of preventive care to eligibility for other social benefits (such as conditional cash transfers) could help increase coverage among low-income households.

  • Addressing supply side barriers in less developed areas. Since many low income households reside in less developed areas or neighborhoods, availability of health care facilities and health care professionals—in particular those with similar quality as in more affluent areas—can be a major barrier to access. This may require public provision of health care as the last resort or additional incentives for service provision by private providers in these areas. Tanzania and Uganda managed to expand access to health care. Both countries significantly increased public spending on health and channeled resources through improved public expenditure frameworks. Tanzania increased public health spending almost threefold, from 1.3 percent of GDP in 1998, to a peak of 3.8 percent of GDP in 2006. In Uganda, the increase in public spending was also significant; from 0.1 percent of GDP in 1998 to 1.2 percent in 2003, after free primary health care was introduced.

Policies to Increase Total Factor Productivity

Fiscal policy can raise total factor productivity through several channels, including by stimulating R&D and providing critical infrastructure. It can also help enhance the sustainability of growth by addressing negative environmental externalities.

35. The supply of key public goods can raise total factor productivity. In addition to enhancing the economy’s productive capacity as discussed earlier, public investment in physical infrastructure can improve the productivity of private capital and raise its rate of return (Munnel, 1992; Easterly and Rebelo, 1993). Similarly, public spending on education can also accelerate technology catch-up and enhance local productivity by improving the ability of the domestic labor force to absorb cutting edge technologies from the global economy (Everaert and others, 2014; Dhont and Heylen, 2009).

36. Well-targeted R&D tax incentives can support lasting growth. Figure 10 illustrates the positive relationship between spending on R&D and growth. R&D tax incentives generally take two forms: (i) tax credits that reduce the costs of R&D; and (ii) special intellectual property (IP) boxes that reduce the tax burden on profits earned from patents and trademarks. The former are truly geared toward encouraging innovation, while the latter are more likely used as a tool for tax competition. In advanced economies, R&D tax provisions are found to have a positive, albeit relatively small, impact on total factor productivity; this effect is larger for R&D intensive industries (OECD, 2010a).

  • Country studies show that a few countries provided tax credits and extended deductions of R&D-related spending with some success (Ireland, Malaysia, and Poland). In Ireland, business expenditure on R&D grew by 80 percent between 2003—the year before the introduction of the tax credit regime—and 2012 (Hynes and O’Connor, 2014). In Poland, five-year growth in real R&D spending accelerated from 32 percent in the pre-reform period (1994–99) to 63 percent in the post-reform period (2005–10).

  • In addition to tax measures, a number of countries increased public spending on R&D. For example, in the Netherlands, public spending on R&D increased by 8 percent during a substantial expenditure-based consolidation in the mid-1980s.

Figure 10.
Figure 10.

R&D Expenditure and Growth, 2001–2012

(Percent)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: WDI.Note: Excludes countries with fewer than five observations during the considered period.

37. However, similar to tax incentives in general, R&D tax incentives can be distortive and ineffective if not designed carefully. In addition to the care that is required in designing tax incentives in general (as discussed under Policies to Enhance Investment in Physical Capital), the design of incentives targeted at encouraging R&D requires particular attention. Empirical evidence on positive effects of such incentives on innovation and growth remains relatively scant. This could be due to R&D spending actually translating into only modest social benefits. Importantly, in countries where the capacity for carrying out R&D activities is limited by human capital constraints, the case for such tax incentives is less compelling, and other measures (such as incentives for technology transfers) may be better suited to boost productivity.

C. Fiscal Space for Pro-Growth Reforms

In some instances, the implementation of growth-friendly fiscal reforms will require fiscal space. While revenue measures should focus on minimizing distortions, expenditure reforms should primarily address inefficiencies in spending. Such policies would not only provide fiscal space but also contribute directly to medium- to long-term growth. Policies to reduce energy subsidies and introduce environmental taxation would address negative externalities, as well as generate resources for growth-enhancing interventions. For countries facing difficulties in expanding fiscal space, the focus should be on budget-neutral fiscal reforms.

38. Growth-friendly fiscal reforms may require fiscal space.17 For example, given a tight budget constraint, revenue losses from lowering highly distortionary taxes (e.g., labor taxes) would need to be offset by other tax measures and/or spending cuts. Similarly, increased spending on public infrastructure, health, and education would need to be financed either through additional revenue or through reductions in other public spending. Additional borrowing is an option for countries where fiscal sustainability and rollover risk are not a concern.

39. Countries that opt to create fiscal space through revenue measures should focus on less distortionary taxes and base-broadening measures. Such measures could include:

  • A shift in the revenue composition toward more growth-friendly taxes. As noted above, corporate income taxes have the most negative effect on growth, followed by labor income taxes, then indirect taxes, and finally property taxes (IMF, 2013a). However, most countries rely to a great extent on direct tax revenue (Figure 11). In many countries, closing value-added tax (VAT) policy and compliance gaps would both improve revenue collection and remove inefficiencies (IMF, 2013a). Increasing excise taxes on alcohol, tobacco and even sugar, can be justified on the grounds of their possible harmful health effects. The regressive impact of higher indirect taxes can be compensated by expanding spending on programs that benefit the poor relatively more. In Poland, a reduction in the share of direct taxes in overall tax revenues from 45 percent to 36 percent contributed to a significant increase in investment and employment In Chile, an early introduction of a broad-based VAT with limited exemptions, helped to reduce distortionary effects of sales taxes and yielded substantial revenue gains. In both countries growth improved following the reforms.

  • Base-broadening measures. These often include rationalizing tax exemptions and preferential regimes. Eliminating preferential treatments or improving their targeting could yield higher revenue and improve horizontal equity while enhancing growth. A number of countries combined tax rate reductions with tax base broadening. Australia in the 1980s launched a tax reform which cut tax rates and tightened tax exemptions in such areas as agriculture, forestry and film production. In Malaysia in the late 1980s, growth-friendly tax cuts (profit and trade taxes) were partially offset by broadening the sales tax base; and in Uganda, civil servants’ salaries were made taxable, while tax exemptions were curtailed.

  • Improvements in revenue administration. Tax compliance affects the revenue yield, efficiency and fairness of a tax system (IMF, 2015b). Effective revenue administration reforms include the introduction of risk management techniques and segmentation of taxpayers (e.g., establishment of large taxpayer units). In addition, simplification of laws and procedures can help reduce the cost of taxpayer compliance. In Chile, for instance, simplification of taxpayer forms and streamlining of filing and payment procedures contributed to improved enforcement and tax collection. Tanzania and Uganda created a unified revenue authority. Conditionality under Fund-supported programs can help: Crivelli and Gupta (2014) estimate that tax revenues increased by approximately ½ percentage point of GDP in a given year in countries where Fund-supported programs included conditionality on tax policy and administration.

Figure 11.
Figure 11.

Revenue Structure by Country Group, 2009–2013

(Percent of GDP)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations.
Figure 12.
Figure 12.

Public Expenditure Composition, 2007–2013

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations.

40. Countries that opt to create fiscal space through spending measures should focus on rationalizing spending and improving efficiency. Such measures could include:

  • Rationalizing spending. Spending on wages, subsidies and social benefits accounts for around three-quarters of total spending in advanced and emerging economies (Figure 12). Priority areas that could be examined for rationalization therefore include the government wage bill, especially where public sector wages and employment are high relative to the private sector; and social spending, in particular where it is poorly targeted. For example, in advanced economies, only one-fifth of total spending on family benefits was means-tested in 2011; and in low-income countries, social assistance programs are often prone to leakages and insufficient coverage of eligible populations (IMF, 2014f). Country studies illustrate how public wage bill rationalization helped create fiscal space and contributed to wage moderation in the Netherlands, Ireland, Germany, and Malaysia (Figure 13). The redesign of social transfers formed part of broader adjustment packages in the Netherlands, Chile, Germany, and Poland.

  • Improving efficiency. Many countries could enhance the delivery of essential public services while saving resources by improving the efficiency of spending. For example, at least 20–40 percent of health spending is typically wasted (World Health Organization, 2010), and, as noted earlier, there is scope for substantial gains in health indicators at current levels of spending (Grigoli and Kapsoli, 2013). With regard to education, trends in the wage bill in many advanced countries do not reflect the fact that teacher-student ratios are falling. Implementing a per-student financing formula such as in the Netherlands could ensure that wage costs remain in line with the number of students and potentially generate savings that could be used to enhance the quality of school infrastructure and teaching materials (IMF, 2014f). The potential for efficiency improvements also extends to quasi-fiscal activities. For instance, reform of inefficient SOEs and privatizations provided significant fiscal space in Chile, Tanzania, and Malaysia.

Figure 13.
Figure 13.

Public Wage Bill Post-Reform

(Index, reform period t = 100)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: ECB, Haver, IMF staff calculations, and WEO.

41. Policies to address negative environmental externalities can also create fiscal space. Fiscal policy has an important role to play in building greener economies and boosting environmentally sustainable growth by pricing environmental externalities and improving resource allocation. At the same time, eliminating energy subsidies and introducing environmental taxation can generate substantial fiscal resources:

  • Generalized energy subsidies distort consumption and production decisions, and constitute a poor instrument for income redistribution (Arze del Granado and others, 2012). In 2015, spending on energy subsidies (on a post-tax basis) is projected to reach US$5.3 trillion (or 6½ percent of global GDP).

  • Carbon or congestion taxes are aimed at reducing greenhouse gas emissions and pollution. Potential revenue gains from these environmental taxes could amount to 2.9 percent of global GDP (Gupta and Keen, forthcoming).

D. Growth and Equity

Income inequality affects growth in its own right and an overall assessment of growth-enhancing fiscal reforms needs to reflect their distributional consequences. While some growth-enhancing reforms can have a negative impact on income inequality, country studies illustrate strategies to mitigate equity-efficiency tradeoffs.

42. Income equality can lead to higher long-term growth through faster human and physical capital accumulation. At low levels of income, some degree of inequality can spur growth by raising savings and investment (Kaldor, 1957) and allowing at least a share of the population to start businesses and get a good education (Barro, 2000). However, with rising inequality the relationship may turn negative (Benhabib, 2003). Recent studies indicate that high levels of inequality are, overall, harmful for the pace and sustainability of growth (Berg, Ostry and Zettelmeyer, 2012; Ostry, Berg and Tsangarides, 2014). Education and health outcomes of the poor tend to be better in a more equal society, due to higher personal income, larger transfers from the government, and/or better public services. This can lead to a faster accumulation of human capital (Perotti, 1996; Galor and Moav, 2004; Aghion, Caroli, and Garcia-Penalosa, 1999). In addition, higher income equality can expand the size of domestic demand and support higher physical capital accumulation (Murphy, Shleifer and Vishny, 1989).18

43. Some reforms that increase efficiency have adverse distributional consequences. For instance, a shift from direct to indirect taxes, aimed at reducing distortions and promoting growth, can reduce the progressivity of the tax system and increase inequality. A reduction in social transfers—aimed at encouraging labor participation—might likewise have a detrimental impact on equity. In particular, measures such as public employment reductions or pension freezes can increase unemployment and reduce the purchasing power of lower income groups, with adverse consequences for the income distribution (Ball and others, 2013; Woo and others, 2013). In the country studies, inequality worsened especially where current spending cuts involved reductions in social benefits, including in Chile and Germany (Figure 14). In Australia, income inequality widened in part because the reforms in the 1980s increased wage dispersion, and the introduction of the GST in the early 2000s reduced the progressivity of the tax system (Singh and others, 1998; Greenville and others, 2013).

Figure 14.
Figure 14.

Trends in Inequality Post-Reform

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations, SWIID 5.0.1/ Refers to Gini coefficient after taxes and transfers.

44. Appropriately designed, fiscal reform packages can serve both growth and equity objectives.19 Cross-country analysis finds that a reduction in inequality does not diminish the association between fiscal reforms and growth accelerations. For example, if the proceeds of a regressive, yet growth-enhancing tax reform are used to finance higher health and education spending, the overall outcome may be higher growth and lower inequality (Muñoz and Cho, 2004; IMF, 2014e). In particular, providing conditional cash transfers tied to the schooling of young children, especially girls, can reduce inequality and boost human capital. Reducing evasion and tax expenditures or loopholes that largely benefit the rich can simultaneously benefit growth and income equality (Blanchard and Cottarelli, 2010). More generally, a tax system that is perceived to be “fair” is associated with improved tax compliance (IMF, 2015c). Despite a sharp reduction in public spending, income inequality did not increase significantly after Ireland’s first reform episode in the late 1980s. This reflects the composition of fiscal adjustment—specifically the fact that cuts in public sector wages and untargeted transfers turned out to be progressive—as well as the sharp increase in employment subsequent to reforms (Bastagli, Coady and Gupta, 2012; IMF 2014e). In Malaysia, spending to reduce ethnic inequality was protected when a 10 percent of GDP cut in primary spending was instituted during the second half of the 1980s. Measures that helped reduce inequality and poverty included the public provision of health and education services, in particular in rural areas; a system of targeted transfers; and education and technical training to facilitate mobility from agriculture to higher-value added activities.

The “How” Matters: Design and Implementation of Reforms

How fiscal reforms are designed and implemented are key determinants of their success in generating strong and sustained growth. The most critical considerations in this regard include social dialogue around key reform areas; policy complementarities; consistency with structural and macroeconomic policies; and policy credibility.

45. Social dialogue enhances the likelihood of reforms being implemented and sustained. In advanced economies public sector employment reforms that involved social dialogue resulted in much deeper and more sustained reductions in the wage bill (IMF, 2014f). Examples of such reform episodes include the Netherlands and Ireland. The Netherlands’ Wassenaar agreement (1982) and Ireland’s tripartite agreement (1987) facilitated the implementation of politically difficult measures such as cuts in benefits and wage moderation.

46. A number of strategies can help foster public support for reforms. Effective communication with stakeholders that emphasizes the intended benefits of reforms—or the cost of maintaining the status quo—can help mitigate resistance to reforms (as arguably occurred in Germany in 2003). Also, inclusion of compensatory measures for those expected to lose from reforms has been found to be effective in gaining public support for reform packages. In Ireland and the Netherlands, real wage growth reductions were compensated with tax cuts to mitigate the impact on disposable income (Figure 15); and cuts in social benefits were made more palatable by the promise of job-creation in the private sector. Common policy anchors can help forge consensus. In Poland, for instance, the prospect of EU-accession was critical in overcoming resistance to pension reform and reductions in social benefits. In most cases, countries apply a combination of strategies (Clements and others, 2013).

Figure 15.
Figure 15.

Ireland: Tax Cuts and Wage Moderation

(Percent)

Citation: Policy Papers 2015, 023; 10.5089/9781498344654.007.A001

Source: IMF staff calculations.

47. Successful fiscal reforms exploit policy complementarities to maximize their impact on growth, and are generally accompanied by supportive structural reforms and macroeconomic policies:

  • Fiscal policy complementarities. In all countries studied, policy design helped fiscal measures reinforce each other. For example, in the Netherlands, Ireland and Germany, work incentives were enhanced by reducing benefits and income taxes. Countries simultaneously reduced corporate/personal income taxes and current spending, in order to stimulate private investment and employment while improving public finances (Poland, Australia, Ireland, Netherlands, Chile, and Malaysia). Complementary steps are often necessary to reap positive outcomes: for example, in a country with weak governance, scaling up public investment would need to be preceded by improvements in public financial management— which Tanzania strived to do. Staffs analysis of growth acceleration episodes points to the potential benefits of policy complementarities: the likelihood of growth acceleration is higher when expenditure and revenue reforms are combined.

  • Supportive structural reforms in other areas. Broader structural reforms can help to boost medium-to long-term growth and magnify the impact of fiscal reforms. In the majority of the country studies, fiscal reforms were implemented together with other structural reforms. To boost employment, countries combined strengthened work incentives with labor market reforms aimed at facilitating job creation, such as streamlined hiring/firing procedures, changes in wage bargaining, and minimum wage cuts (Netherlands, Ireland, and Germany). In other cases, fiscal consolidation to create room for corporate tax reductions was pursued simultaneously with economic deregulation and privatizations (Netherlands, Malaysia, and Chile). In Tanzania, opening up the economy, including through trade liberalization, helped enhance the effectiveness of fiscal reforms and create a favorable environment for private-sector development.

  • Consistent macroeconomic policies. Reform packages also require a “two-handed approach” (Blanchard and others, 1985) where macroeconomic policies support structural reforms. For example, a transitory loosening of the fiscal stance can buy valuable time to implement labor market reforms. In this regard, a slower pace of consolidation may be required to absorb the potential costs of structural reforms (IMF, 2014a).

48. The credibility of reforms can boost their effectiveness and impact on medium- to long-term growth. Recent evidence for advanced economies confirms that the establishment of a credible medium-term adjustment path matters more for instilling market confidence than the initial fiscal adjustment effort (Harris and others, 2013). Policy credibility can thus allow for an even distribution of adjustment effort over time—or even back-loading—and hence minimize the potential negative impact on longer-term growth from hysteresis effects (IMF, 2013b).

Table 1.

Menu of Options: Fiscal Policies for Medium- to Long-Term Growth

article image
Note: ‘xxx’ denotes highly relevant policy, ‘xx’ denotes moderately relevant policy and ‘x’ denotes less relevant policy.

Lessons for Policymakers: an Agenda for Reform

49. There are many ways in which fiscal policy can support medium- to long-term growth (Table 1). In designing growth-friendly fiscal policies, consideration should be given to country-specific needs, circumstances, and administrative capacities.

  • ✓ Macroeconomic stability is an essential prerequisite for strong and sustained growth.

    • Large fiscal deficits reduce aggregate savings in the economy and may lead to inflation, high interest rates, and balance of payments pressures. Policy uncertainty, high levels of public debt, and high inflation, can deter private investment.

    • Fiscal frameworks that facilitate the symmetric functioning of automatic stabilizers can reduce macroeconomic volatility and uncertainty and foster medium-term growth.

    • Careful consideration needs to be given to the pace of fiscal consolidation. Countries that are not under market pressure should proceed with gradual fiscal consolidation, anchored in a credible medium-term plan.

    • The composition of adjustment matters for growth. Expenditure-based consolidations are typically more durable and supportive of longer-term growth; however, in some cases revenue-based consolidations may be more appropriate and equity-friendly.

    • Not all countries need to adjust, however: many low-income countries may have fiscal space for productive spending on infrastructure and critical social services.

  • ✓ Policy design and social consensus matter for the successful implementation of reforms.

    • Structural reforms can promote savings, stimulate investment, and unlock productivity gains. To be successful, fiscal measures should be mutually reinforcing and may need to be accompanied by supportive structural reforms and macroeconomic policies.

    • Appropriately designed fiscal reform packages can serve both growth and equity objectives: for example, if revenue from relatively regressive tax reforms is used to finance higher health and education spending, the overall result can be higher growth and lower inequality.

    • Social consensus increases the likelihood of reforms being implemented and sustained. A number of strategies can help foster public support for reforms, including effective communication with stakeholders, and compensatory measures for those expected to lose from reforms.

  • ✓ Specific tax and expenditure policies can help growth.

    Policies to increase the labor supply

    In many advanced economies, significant distortions arise from the tax-benefit system:

    • Lowering the labor tax wedge increases after-tax earnings and the supply of labor, particularly for younger workers, women and the low-skilled;

    • Redesigning unemployment benefits by conditioning eligibility on participation in ALMPs and increasing the use of in-work benefits can better support job-seekers—especially unemployed youth— and strengthen work incentives;

    • Introducing targeted measures can encourage the labor force participation (LFP) of particular groups:

      • Women: improving the design of family benefits, including paid parental leave; providing more flexible work options; and ensuring the availability of affordable child care;

      • Older workers: lowering implicit taxes on continuing work, increasing the effective retirement age, and adjusting pension benefits to actuarially fair levels that do not distort participation decisions, while ensuring effective protection against old-age poverty; and

      • Low- skilled workers: providing in-work tax credits, hiring subsidies, and tailored support through ALMPs.

    • Promoting equitable access to education, and dismantling legal obstacles to work for women could increase LFP in developing economies.

      Policies to enhance investment in physical capital

    • In advanced economies, reforming the corporate income tax to tax “excess returns” or rents, e.g., through an allowance for corporate equity (ACE), can reduce distortions and stimulate private investment;

    • In developing economies, avoiding open-ended tax holidays that erode the tax base indefinitely and providing instead targeted and transparent incentives that reduce the cost of capital, such as accelerated depreciation schemes, investment tax credits, and super deductions, can promote investment; and

    • Putting in place efficient public investment processes and prioritizing infrastructure can help reverse the decline in public capital stocks in advanced economies and help close infrastructure gaps in developing economies. This can boost growth directly and indirectly by raising the productivity of private capital.

      Policies to support human capital development

    • Human capital accumulation can be supported by improving access to education for disadvantaged groups and increasing investment in lower levels of education; as well as ensuring universal access to a basic package of health services by reducing or waiving user charges for poor households.

    • In developing economies, addressing supply-side barriers in remote areas and conditioning cash transfers on school attendance and preventive health visits can further promote access to health and education services; and

    • In advanced economies, allowing for deducibility of education expenses or providing tax credits can encourage private investment in education.

      Policies to increase total factor productivity

    • In line with administrative capacities, countries can pursue improvements in productivity through targeted and transparent tax incentives such as tax credits that reduce the cost of R&D and encourage investment in new technologies.

    • In most developing and many advanced economies, better public infrastructure can lift growth through both the investment channel and through total factor productivity.

  • ✓ If growth-friendly reforms require fiscal space, resources should be made available in the least harmful way for growth and equity.

    • Broadening the tax base by rationalizing tax exemptions and preferential regimes raises revenue and boosts horizontal equity.

    • Shifting the tax composition to the least distortionary taxes such as taxes on consumption, increases efficiency. Taxes on property or wealth can also increase the progressivity of the tax system.

    • Improvements in revenue administration including through introducing risk management techniques, segmenting taxpayers, and simplifying laws and procedures, can strengthen taxpayer compliance and enhance revenue collection as well as equity.

    • Rationalizing the government wage bill where public sector wages and employment are high relative to the private sector; and improving the targeting of social spending can increase expenditure efficiency.

    • Addressing environmental externalities by phasing out energy subsidies and introducing environmental taxation can create fiscal space while facilitating implementation of growth-enhancing measures, such as lower wage taxation.

    • For countries facing difficulties in expanding fiscal space, the focus should be on budget-neutral fiscal reforms.

Issues for Discussion

50. This paper finds that fiscal policy can play an important role in strengthening sustained and inclusive growth. Directors’ views and guidance on the analysis and recommendations contained therein would be welcome. Specifically:

  • Do Directors agree that fiscal policy can be an effective tool for supporting medium- to long-run growth?

  • Do Directors agree that the mix of fiscal policy options should be tailored to country-specific conditions, administrative capacities and preferences?

  • Do Directors agree that the growth dividends of fiscal reforms depend to a large degree on complementary structural reforms and supportive macroeconomic policies?

  • Do Directors agree that strategies such as effective communication with stakeholders, and compensatory measures for those made worse off can help foster public support for fiscal reforms?

  • Do Directors agree that both growth and equity objectives can be achieved when fiscal reform packages are appropriately designed?

  • In cases where countries need to mobilize resources to create space for growth-friendly policies, do Directors agree that the tax and spending policies identified in the paper are the least harmful for growth?

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