Introduction¹

1. This note responds to a request from the G20 for IMF assistance in helping develop priorities and guiding principles for structural reforms. Against the background of a weakening recovery and slowing potential growth, it has become even more urgent for G20 countries to reinvigorate their commitment to ambitious structural reforms. This note presents a framework to identify and prioritize structural reforms, taking into account country differences. The framework brings together the identification of policy gaps in the structural area, with an assessment of the macroeconomic environment in which structural reforms might be implemented, including countries’ income level, cyclical position, and available macroeconomic policy space. As a rule, securing higher, stable, and sustainable growth will require a well-designed mix of mutually reinforcing supply and demand policies.

Background and Policy Context

2. The global recovery has weakened further and the global economy is highly vulnerable to adverse shocks. Activity softened towards the end of 2015 and the likelihood of a further downgrade of the outlook has increased. Against a background of heightened financial market volatility and concerns about the lack of policy space, financial conditions have tightened, especially for emerging market economies. This adds to existing concerns about the global impact of demand rebalancing in China and the impact of falling commodity prices on emerging markets, as well as non-economic risks such as the refugee surge in Europe or a possible exit of the U.K. from the European Union.

3. The further weakening in economic activity comes at a time of declining potential output growth. In many advanced economies this decline started as far back as the early 2000s and accelerated with the impact of the Great Recession on investment and employment. Potential growth has also weakened in emerging economies since the crisis, due to lower growth of total factor productivity and of investment.

4. The fragile conjuncture increases the urgency of a broad-based policy response that strengthens growth and manages vulnerabilities. In advanced economies, this requires a mix of mutually reinforcing demand and supply policies, including continued accommodative monetary policy and supportive fiscal policies—making the best possible use of fiscal space (for example, through infrastructure spending) where it exists and ensuring a strong medium-term fiscal framework is in place. In emerging market economies, it requires reducing vulnerabilities and rebuilding resilience—for example, by strengthening fiscal buffers and diversifying growth in commodity-exporting countries. Reinvigorated structural reforms are a critical element of the necessary policy package.

The G20’S Commitment to Structural Reforms

5. Structural reforms have been central to the G20’s strategy of achieving strong, sustainable, and balanced growth and creating jobs (Box 1). Commitments in the areas of structural policies have been a critical element of successive G20 Action Plans. In 2014, G20 leaders endorsed the Comprehensive Growth Strategies—with over 1,000 structural policy commitments—at the Brisbane Summit. Updated growth strategies, with additional structural policies, were then endorsed at the Antalya Summit in 2015.

6. At their Shanghai meeting in February 2016, Finance Ministers and Central Bank Governors reaffirmed the role of mutually-reinforcing macroeconomic and structural policies. Reflecting on the relatively weak implementation of structural reforms so far and disappointing economic growth, they noted that faster progress on structural reforms should bolster potential growth in the medium term, and make their economies more innovative, flexible, and resilient. To this end, they committed to identifying three high impact measures as their key commitments for delivering stronger growth.

Placing Structural Reforms into a Comprehensive Policy Context

7. Structural reforms should be considered within the broader macroeconomic context to maximize their impact within the larger growth-enhancing strategy. Specifically, the design of structural reforms should take into account their short-term impact on demand. While some types of reforms tend to support short-term growth, others do not, possibly adding to a shortfall in domestic demand. This could further weaken potential output due to hysteresis effects, which, in turn, can depress expected future income and firms’ profitability, thereby reducing consumption and investment today. Mutually reinforcing demand and supply policy actions are therefore essential to address these near and medium term challenges.

C. Interaction between Structural Reforms and Demand Policies

10. Structural reforms can make demand policies more effective. An important example is structural reforms that address imperfections in the financial sector. In addition, reforms that increase the responsiveness of wages and prices to business conditions can promote microeconomic efficiency while enhancing economic resilience, by strengthening the ability of macroeconomic policies to smooth economies’ response to shocks.

11. However, some reforms entail transitory costs, especially when macroeconomic conditions are weak. For example, new IMF analysis suggests that looser employment-protection legislation may increase unemployment in the short term when current and expected future growth are low—while the incentives for incumbent firms to recruit are increased given looser employment protection, firms’ willingness to recruit, and of new firms to enter the market, are reduced given the economic climate. Furthermore, some structural reforms may result in slower wage and price growth, which could lower expected inflation and can increase the real interest rate, especially where monetary policy is operating at the zero lower bound.

12. This suggests that demand policies can play a critical role in enhancing the benefits of structural reforms. While the rationale for structural reforms does not depend on the availability of demand policies, in some cases, demand policies can help bring forward the long-term gains of structural reforms. In other cases, they may alleviate their short-run costs, particularly under weak macroeconomic conditions. Demand policies will generally involve all standard tools; however, depending on country circumstances, the availability of monetary and fiscal policy might depend on the available policy space. Specifically, there are two inter-related, but conceptually distinct, channels through which accommodative macroeconomic policies can increase the short-term impact of structural reforms on output and employment:

• Amplifying structural reform effects. By improving overall business conditions, macroeconomic policy stimulus improves the incentives of firms and workers to respond positively to structural reforms. For example, new IMF research finds that the employment gains from reducing excess job protection will be larger when accompanied by fiscal expansion (Figure 1, upper panel). Thus, the benefit of implementing structural reforms and demand support together exceeds the sum of the benefits from implementing them separately, as firms are more willing to recruit new employees (and retain those already employed). Likewise, workers may be less likely to reduce their consumption in response to a cut in unemployment benefits when there is fiscal stimulus. There is also some tentative evidence that fiscal policy support accelerates the entry of new firms when entry barriers are lowered.

• Larger payoffs for structural reforms that entail additional fiscal support. New IMF research suggests that reforms such as reductions in labor tax wedges and increases in public spending on active labor market policies have larger positive effects during periods of low growth and when not accompanied by offsetting spending cuts or tax increases (Figure 1, lower panel). This is because such reforms entail a fiscal multiplier effect, which in general tends to be larger in bad times, when output gaps are large.

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Impact of Selected Reforms under Alternative Macroeconomic Conditions and Policies

Citation: Policy Papers 2016, 001; 10.5089/9781498345798.007.A001

Source: IMF Staff analysis.Note: t=0 is the year of the reform shock—major historical reform of employment protection legislation (upper two charts) and a one percentage point change in the labor tax wedge (lower two charts), respectively. Solid blue lines denote the estimated response to the shock, and dashed blue lines denote 90 percent confidence intervals. The solid red line shows the unconditional result, i.e. the average estimated impact across fiscal and growth regimes, respectively. Both the fiscal regime (fiscal expansion vs. contraction) and the growth regime (high vs. low growth) are defined using a smooth transition function as in Auerbach and Gorodnichenko (2012): $F\left(z_{it}\right)=\frac{\exp (-\gamma z_{it})}{1+\exp (-\gamma z_{it})},\gamma >0$, in which z is an indicator of the stance of fiscal policy or the state of the economy normalized to have zero mean and unit variance. The indicator of the stance of fiscal policy is a government consumption shock, identified as the forecast error of government consumption expenditure relative to GDP (see e.g., Auerbach and Gorodnichenko 2012 and 2013; Abiad, Furceri and Topalova 2015). The indicator of the state of the economy is GDP growth. The charts show estimated impulse responses for hypothetical very large and very low values of the smooth transition function.

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A Conceptual Framework for Prioritizing Structural Reforms

13. The prioritization of reform options starts with the assessment of each country’s structural policy gaps. This will generally leave policymakers with a wide array of potential reforms, drawn from the priority areas and affecting growth through total factor productivity, capital, employment, or the capacity to adjust For example, in countries with weak or declining productivity growth relative to best-performing countries, potential reforms could be aimed at increasing competition in domestic and external markets as well as policies that promote innovation and technology diffusion. Similarly, in countries with weak employment performance, labor market reforms as well as policies to increase labor market participation of underrepresented groups could be considered. Policymakers can draw on several sources for input on where their performance gaps are largest. The assessments undertaken by the OECD in the context of its “Going for Growth” framework would be particularly useful to identify where the performance gaps may be most significant.

14. A crucial next step is to take into account the macroeconomic environment. The previous discussion and ongoing analytical work undertaken by the IMF suggests a framework to help policymakers select and sequence their reform agenda, taking into account the large diversity of individual country experiences. The framework includes three macroeconomic dimensions: (i) a country’s income level, (ii) its position in the economic cycle, and (iii) its resource space to finance reform.

15. A first dimension is the country’s income level. Countries should generally prioritize structural reforms in areas that have been identified as having a high pay-off for their respective level of economic and financial development. IMF research³ finds that some structural reforms have the potential for large payoffs in both advanced and emerging markets—for example, infrastructure and banking sector reforms, as well as fiscal reforms aimed at strengthening tax administration and improving spending efficiency. However, the specifics can differ between different country income groupings, and the nature and effect of many other reforms can vary significantly depending on the level of economic development (Figure 2):

• For emerging market economies, the largest productivity payoffs are associated with reforms that improve market functioning—in particular, those that focus on business regulations, labor markets, and infrastructure. Capital market development also has the potential to deliver significant benefits, especially in countries with weak legal systems and property rights.

• For advanced economies, higher priority should be given to reforms geared toward supporting technological progress. Labor and product market reforms, as well as innovation, appear to have the greatest productivity payoffs, particularly for economies closest to the technology frontier.

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Structural Reforms with the Highest Productivity Payoffs Within Each Country Group

Citation: Policy Papers 2016, 001; 10.5089/9781498345798.007.A001

Note: Comparisons across reforms w ithin each country group. Darker shades imply larger gains from reforms.

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16. A second dimension is the country’s position in the economic cycle. The larger a country’s output gap (Figure 3), the more it should prioritize structural reforms that will support growth both in the short and the longer term—for example, eliminating labor tax wedges and increasing spending on active labor market policies or infrastructure investment. Such measures also tend to have higher fiscal multipliers in times of large economic slack.

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2016 Output Gap (In percent of potential GDP)

Citation: Policy Papers 2016, 001; 10.5089/9781498345798.007.A001

Source: WEO January 2016 Update

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17. A third dimension is the country’s resource space for reform. A country’s resource envelope will play an important role in determining whether—and if so, how—to implement certain structural reforms. Where budget constraints are binding, the sequencing of reforms might have to be adjusted to favor lower- or no-cost measures with positive demand effects of their own (e.g., reducing product market entry barriers), or budget-neutral reform packages (e.g., an increase in infrastructure spending financed by a reduction in energy subsidies). Moreover, the absence of fiscal space for demand support will make it less attractive to implement reforms with possible negative short-term growth effects, especially in times of economic slack (see below). Where such reforms are necessary and cannot be delayed, but budget constraints are binding and other macroeconomic policy tools (e.g., monetary policy) are not available, it will be important to form realistic expectations about the time required for these reforms to have a positive impact on growth.

18. Where there are tradeoffs between growth—the core focus of the proposed framework—and other public policy objectives, policy choices will also be shaped by each country’s societal preferences. For example, a given performance gap can sometimes be addressed through alternative policy options, whose implications for other policy objectives may differ. For example, both the Anglo-Saxon and the Nordic “flexicurity” approaches have been successful in achieving high and stable employment. But they are based on different labor market policies, with different implications for inequality.

Application of the Conceptual Framework

19. How would the conceptual framework described above be applied? The framework suggests that the macroeconomic circumstances of countries can differ along three key categories, including their income level (advanced or emerging economy), cyclical position (below or around/above potential), and policy space (available or limited). The examples below seek to explain how the framework might be applied, in principle, in the following cases: (i) an advanced economy with some policy space and output around potential; (ii) an advanced economy with little policy space and output below potential; and (iii) an emerging economy with little policy space and output below potential.

Next Steps

23. The conceptual framework set out above may be useful to policymakers when considering their structural reform agenda. This guidance may be particularly timely, given the G20’s commitment to reinvigorate their growth strategies. It may also serve as a useful tool for the peer review framework.

24. As G20 countries review their structural reform commitments and potentially seek to identify new ones, they can also draw on the advice of international institutions. The IMF identifies macro-critical structural reforms in its Article IV staff reports. The OECD highlights reforms with the greatest productivity pay-offs in its “Going for Growth” recommendations. While there is considerable overlap of reform recommendations and commitments in most cases, there are also areas of divergence, including from the priorities that have been set out by G20 countries themselves. The conceptual framework discussed above can facilitate the prioritization of structural reforms also in this context. The IMF stands ready to contribute to this effort, together with other international organizations.