Exchange Rate Strategies and Fiscal Performance in Sub-Saharan Africa
Author:
Mr. Karim A. Nashashibi
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and
Mrs. Stefania Bazzoni
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Contributor Notes

* Karim Nashashibi is Assistant Director of the Middle East Department. He holds a Ph.D. from the University of California at Berkeley. Stefania Bazzoni, a doctoral candidate at the Institut Universitaire de Hautes Etudes Internationales (Geneva), contributed to this paper as a summer intern in the Fiscal Affairs Department in 1992. The paper also benefited from the comments of Tamim Bayoumi, Carlo Cottarelli, Pierre Dhonte, Christian Francois, Alejandro Garcia, Robert Hagemann, Daniel Hewitt, Malcolm Knight, and Vito Tanzi. Tarja Papavassiliou and Eric Sidgwick provided valuable research support, and Derek Bills was helpful in generating the charts.

Publication Date:
01 Jan 1994
eISBN:
9781451957037
Language:
English
Keywords:
SP; IMF working papers Policy Analasis; nominal exchange rate; fixed-rate country; import unit value; import substitute; import substitution sector; Imports; Terms of trade; Real exchange rates; Africa
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This paper investigates the relationship between fiscal performance and movements in the exchange rates, the terms of trade, and other macroeconomic aggregates in 28 sub-Saharan African countries over the 1980–91 period. It finds that the tax base in most of these countries is heavily dependent on imports and import substitutes. Consequently, an overvaluation of the exchange rate in countries that adopt a fixed exchange rate strategy (CFA franc zone countries), when the purpose of the strategy is to restore the real exchange rate to its equilibrium through fiscal contraction, can result in a widening of the fiscal deficit. Those countries with a variable exchange rate strategy fail to attain price stability but are able to enhance their fiscal balance, competitiveness, and growth.

Abstract

This paper investigates the relationship between fiscal performance and movements in the exchange rates, the terms of trade, and other macroeconomic aggregates in 28 sub-Saharan African countries over the 1980–91 period. It finds that the tax base in most of these countries is heavily dependent on imports and import substitutes. Consequently, an overvaluation of the exchange rate in countries that adopt a fixed exchange rate strategy (CFA franc zone countries), when the purpose of the strategy is to restore the real exchange rate to its equilibrium through fiscal contraction, can result in a widening of the fiscal deficit. Those countries with a variable exchange rate strategy fail to attain price stability but are able to enhance their fiscal balance, competitiveness, and growth.

Sub-Saharan African countries emerged from the 1970s with large and unsustainable fiscal deficits, stemming from the increase in government spending following the two oil shocks. The commodity price boom, associated with these shocks, increased government revenues and fueled government spending in a broad range of activities, including investment in public enterprises and marketing boards. Because such spending entailed a large expansion in government employment and other recurrent expenditures that are difficult to reverse, it resulted in a structural imbalance between revenue and expenditure, which has persisted in most African countries throughout the 1980s. This internal imbalance was exacerbated by a sharp deterioration in the external environment, characterized by a protracted decline in terms of trade, an increase in real interest rates, and a sharp decline in the availability of external bank credit.

To alleviate both the internal and external imbalances, sub-Saharan African countries pursued two different strategies. Countries in the western and central African monetary unions (the CFA franc zone, in which CFA stands for Communaute Financiere Africaine), retained the “internal” adjustment path predicated on maintaining a fixed exchange rate parity with the French franc to ensure fiscal discipline and low inflation.1 Most other sub-Saharan countries addressed the decline in the terms of trade using a variable exchange rate strategy.2 This “external” adjustment strategy allowed the current account to adjust directly, although at the price of substantially higher inflation.

With a pegged exchange rate, a real devaluation can be achieved through deflationary policies, provided price and wage flexibility prevail. On the other hand, when the tax base is highly dependent on international trade, an overvaluation of the real exchange rate would tend to undermine tax revenue and the attainment of fiscal balance (Tanzi (1989)). With a floating or a managed exchange rate, it could be argued that the inflation generated by the lack of fiscal and monetary discipline would also undermine government revenue—owing to lags in tax collection and adjustments of public utility prices—causing growing fiscal deficits, an unfavorable investment environment, and slow growth (Tanzi (1977)).

This paper argues that for economies in which the tax base is highly dependent on imports and import substitutes, an exchange rate that is adjusted toward its equilibrium level is a critical element in improving fiscal performance. To the extent that an overvaluation of the exchange rate undermines the tax base, internal adjustment may result in a widening of the fiscal deficit, when its very purpose is to restore the real exchange rate to its equilibrium level through fiscal contraction. Hence, presenting the internal and external adjustment strategies as policy alternatives is not meaningful. Rather, these two strategies should be complementary.

Having established a fiscal data base for 28 sub-Saharan countries for the 1980–91 period, the paper assesses the implementation of the two alternative strategies by comparing the fiscal performance of the two groups of countries during the 1980–91 period.

I. Initial Macroeconomic Setting

Government participation and intervention in sub-Saharan African economies have been substantial since independence, reflecting the prevailing view that the investment necessary for development and long-term growth would not be forthcoming through private investment alone.

The 1973 oil shock, associated with a boom in other commodity prices, resulted in a structural shift in the public expenditure pattern in sub-Saharan Africa, seemingly with little concern about the fiscal consequences of a possible sharp decline in future commodity prices. Total public expenditure in sub-Saharan Africa grew from 19 percent of GDP in 1970 to 29 percent of GDP in 1980 (Schelizi, Ghandi, and Ehdaie (1985)). This upward trend was common to virtually the entire region with the exception of Tanzania and Burkina Faso. Moreover, the capital formation component of government expenditures, which was around 5 percent of GDP, expanded very rapidly after 1974; by 1980, it reached 9.3 percent of GDP.3 Beyond a noteworthy improvement in infrastructure, public investment focused on capital-intensive manufacturing aimed at import substitution and sheltered from outside competition by protectionist policies. Much of this investment resulted in large losses for public enterprises and banks and a fall in domestic savings. Other public investment in such areas as health, education, and social infrastructure were accompanied by an increase in public employment, which introduced a secular upward shift in recurrent government spending that has proved difficult to reverse.

On the revenue side, sub-Saharan African countries raised their tax ratios mostly through an expansion in the volume of imports. By the late 1970s, tax revenues were averaging around 17 percent of GDP, and total government revenue was comparable with that of other developing countries (Tanzi (1981)). Despite the improvement in resource mobilization, tax revenue was reaching certain limits imposed by the tax structure, in particular by the high dependence on taxes on international trade.4 Yet attempting to expand the tax base to domestic transactions, without considerable strengthening of tax administration, was difficult to achieve in the short term.

The expansion of government spending, coupled with difficulties in raising additional revenue, generated fiscal imbalances, which were financed primarily by external borrowing at a time when banks were seeking to recycle the oil money and when “sovereign risk” was perceived as minimal. By 1980, the average government deficit, excluding grants, in our sample of 28 countries was 9 percent of GDP, and external debt was ten times higher than in 1970, reaching 35 percent of GDP. Thus, despite the sharp increase in commodity prices in the 1970s, large fiscal imbalances had already appeared as a result of excessive government spending. These imbalances—coupled with the large accumulation of external debt—were inconsistent with the stable macroeconomic environment needed to encourage a strong private sector and sustained growth.

Hence, prior to the deterioration in the terms of trade, sub-Saharan African countries entered the 1980s with a need for lower fiscal deficits in order to correct internal and external imbalances and reduce the crowding out of the private sector. There was also a need to improve public finance management so as to reduce nonproductive expenditures and alleviate the distortions introduced through trade restrictions and high customs tariffs aimed at protecting the manufacturing base.

Initial Imbalances

During the 1980s, different macroeconomic performances between the two groups of countries may be explained by several factors: a different starting point, a different intensity in the external shocks sustained, and a different adjustment strategy. Although both groups had a tendency to overspend during the 1970s, the fixed-rate countries started the decade with lower budget deficit-to-GDP ratios (excluding grants) than did the variable-rate countries (7.6 percent of GDP versus 10.4 percent of GDP). The external current account deficit was also more favorable for the fixed-rate countries (6 percent of GDP) than for the variable-rate countries (10 percent of GDP).

On the other hand, the impact of the increase in the real interest rate and the structure of external debt in the two groups were roughly similar. Between 1980 and 1983, the average ratio of total external debt to GDP was 45 percent for the fixed-rate countries and about 47 percent for the variable-rate countries. The proportion of nonconcessional debt in total outstanding debt in 1980 was 22 percent and 24 percent, respectively, for the fixed- and variable-rate countries.

These figures suggest that, on average, the sharp increase in real interest rates at the beginning of the 1980s affected the two groups of countries in a similar fashion. However, between 1985 and 1991, fixed-rate countries experienced a much sharped deterioration (31 percent) in the terms of trade than variable-rate countries (17 percent).5 This difference comes primarily from export price developments, because movements in import unit values for the two groups of countries increased in a similar fashion. Moreover, this deterioration was more broadly based in the fixed-rate group, where only one country—Senegal—experienced an improvement in its terms of trade since 1985; in the variable-rate group, 5 countries (out of 17) experienced such an improvement (Figure 1).

Figure 1.
Figure 1.

Sub-Saharan Africa: Terms of Trade, 1980–91 (1985=100)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: World Economic Outlook data base and International Financial Statistics.

To summarize, although the fixed-rate countries started the 1980s with much more favorable fiscal and current account positions, they have experienced a sharper decline in terms of trade since the mid-1980s than the variable-rate countries. These factors, coupled with fairly close levels of concessional aid, relative to GDP, would suggest that the overall need for adjustment in the two groups of countries was similar. Thus, an explanation of the divergence in the fiscal (and other macroeconomic) performances of the two groups lies more with policy strategy and its implementation than with differences in initial imbalances or external shocks.

Two Alternative Strategies

An adjustment strategy predicated on a nominal exchange rate anchor has been followed by the 13 members of the West and Central African Monetary unions. Until very recently, their common currency—the CFA franc—has been pegged to the French franc at the rate of CFAF 50 = FF l.6 For about three decades the monetary unions and the peg to the French franc served these countries relatively well. Convertibility of their currency, guaranteed by the French Treasury, and mobility of capital throughout the zone, helped provide these countries with monetary stability, low inflation, and an environment conducive to investment and growth (Boughton (1991)).

One of the main benefits of a fixed exchange rate regime for a small, open economy is that it provides a convenient nominal anchor around which a consistent set of macroeconomic policies can be formulated. However, such an anchor can only hold if both fiscal and monetary discipline are achieved. Such discipline was intended by the institutional arrangements of the two monetary unions, which provided for the independence of the two central banks and which limited the extension of credit to member country governments to the equivalent of 20 percent of the previous year’s fiscal revenue.

To adhere to a common external standard, members of the zone give up the use of the exchange rate as a policy instrument, a cost that depends on the nature of the external shocks. In the event of a temporary shock, this exchange regime can provide sufficient flexibility through the use of external reserves for efficient stabilization. However, a more protracted external shock, such as the deterioration of the terms of trade since 1979, may require a change in relative prices. If a nominal exchange rate adjustment is ruled out, a real exchange rate depreciation has to be brought about through a reduction in nominal prices and wages.7

But, if some degree of wage rigidity exists and no strong productivity gains are made in favor of the traded goods sector, a substantial loss of output and unemployment would be incurred. What is interesting in the fixed-rate countries is that the nominal exchange rate anchor is not determined using a basket of currencies reflecting major export destinations or sources of imports but is pegged to the French franc, which is governed by French macroeconomic objectives, including for the past several years the maintenance of a parity with the German mark.8 Therefore, since the mid-1980s, the fixed-rate countries have suffered two external shocks: a major terms of trade deterioration and an appreciation of the French franc relative to the currencies of the fixed-rate countries’ trading partners, which has been translated into a real appreciation of the CFA franc.

To summarize, saddled with structural fiscal deficits from the outset of the 1980s, the fixed-rate countries have had a single instrument—fiscal policy—to achieve two objectives: (i) to bring down the fiscal deficit to a level that is consistent with the targeted inflation rate set by the two central banks, and (ii) to engineer a change in the relative prices of traded and nontraded goods in response to the decline in terms of trade, so as to restore external competitiveness. Theoretically, a reduction of the fiscal deficit would also reduce the real value of the CFA franc.

In contrast to the fixed-rate countries, the 17 variable-rate countries included in this study are a more heterogeneous group. Nigeria and Zaire, the largest countries in the group, have been pursuing expansionary fiscal and monetary policies resulting in high inflation, albeit with occasional attempts at stabilization. Ghana, Madagascar, Tanzania, Uganda, and Zambia have undergone successive adjustment programs and, with the assistance of the IMF and World Bank, have adopted structural reforms to move away from heavy government interference in the economy. Other countries, such as The Gambia, Malawi, and Zimbabwe, have established a relatively liberal environment stemming from a strong private sector. All the variable-rate countries have allowed the exchange rate to seek an equilibrium, but a number of countries only gradually liberalized their exchange and trade policies during the 1980s.9

While this group of countries used restrictive fiscal and monetary policies to reduce internal imbalances, the fiscal and monetary discipline instilled by an independent central bank was lacking, resulting in relatively high inflation and frequent currency depreciation.

II. Fiscal Performance in the 1980s

Aggregate data on fiscal performance in sub-Saharan countries suggest that little progress was made in reducing fiscal imbalance over the decade. When external grants are excluded, the average deficit remains virtually constant throughout the 1980s at about 8 percent of GDP. Further scrutiny reveals, however, that the aggregate data average out the contrasting performance of the two groups of countries.

Fiscal Deficits

The overall budget deficit (excluding grants) for the fixed-rate countries in 1980–81 averaged 7.6 percent of GDP, or substantially less than the deficit levels for the variable-rate countries (10.4 percent).10 By the end of the decade, the fiscal imbalance in the first group widened to 8.2 percent, while the second group reduced its fiscal imbalance to 6.2 percent of GDP (Table 1 and Figure 2). Most of the deterioration for the fixed-rate countries occurred between 1985 and 1989; moreover, most of the improvement in the variable-rate countries became more difficult to sustain after 1985. Nevertheless, there was some fiscal retrenchment for both groups during the 1989–91 period.

Table 1.

Sub-Saharan Africa: Summary of Fiscal Performance

(In percentage of GDP)

article image
Source: National authorities and IMF staff estimates.
Figure 2.
Figure 2.

Sub-Saharan Africa: Overall Fiscal Deficit, Excluding Grants, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

When interest costs are excluded and the focus is shifted to the deficit measure, which can be directly affected by domestic policy, the difference in performance becomes even more pronounced. Interest costs have been roughly the same for the two groups of countries, doubling from 2 percent of GDP to 4 percent of GDP over the decade. In the fixed-rate countries, there was only a small reduction in the primary deficit—from 5.8 percent of GDP to 4.3 percent of GDP. Only two, Gabon and Senegal, succeeded in generating a primary surplus by 1991, although in the case of Gabon it was mostly the result of higher oil exports and prices. In contrast, the variable-rate countries have experienced a more pronounced and sustained improvement in their primary balance, with the deficit falling from 9 percent of GDP in 1980–81 to 1.3 percent of GDP in 1990–91 (Figure 3).

Figure 3.
Figure 3.

Sub-Saharan Africa: Primary Balance, Excluding Grants, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

Looking at the current fiscal position (defined as the difference between total current revenue excluding grants and current expenditure) sheds further light on the government’s contribution to domestic savings.11 Evidence suggests that after some improvements during the first half of the decade, owing to a depreciation in the real exchange rate and an upturn in commodity prices, fixed-rate countries have not been able to generate public sector savings during the second half of the decade or contribute additional resources to the development of the private sector by reducing the government’s indebtedness to the banking system. The current fiscal balance was in substantial surplus in 1980–81 (3.5 percent of GDP) but declined sharply after 1985 and turned negative in 1987 (Figure 4). The turnaround in the current fiscal balance over the decade (about 4.5 percentage points) is much sharper than the deterioration in the overall fiscal balance, pointing to the major causes of fiscal imbalance for the fixed-rate countries—recurrent revenue and expenditure rather than expanding investment. Nevertheless, because of the improvement in their fiscal performance in 1990 and 1991, Burkina Faso, Gabon, Mali, and Senegal managed to generate a current account surplus.

Figure 4.
Figure 4.

Sub-Saharan Africa: Current Balance, Excluding Grants, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF estimates.

In contrast to fixed-rate performance, the current balance was negative in variable-rate countries at the beginning of the 1980s but improved steadily after 1982, generating a surplus by the end of the decade for about half of the countries in that group. On the whole, the improvement in the current balance of the variable-rate countries was not as pronounced as the improvement in the overall deficit. This suggests a broad-based retrenchment in public expenditures touching both recurrent and investment expenditure.

Sources of Fiscal Adjustment

The fiscal performance of the two country groups is shown in Figure 5. Both groups of countries succeeded in reducing their government expenditures during the 1980s, although the effort was greater in the fixed-rate countries. The major difference in their fiscal performance lies on the revenue front. While the variable-rate countries improved their revenue performance by 2.4 percentage points of GDP, total revenue declined in the fixed-rate countries by 3.2 percentage points of GDP, with the result that, by the end of the 1980s, their revenue ratio stood well below that of the variable-rate countries. The differences in revenue performance were mostly due to tax revenue,12 which declined in fixed-rate countries by 21 percent (from 18.7 percent of GDP to 14.7 percent of GDP) and increased in the variable-rate countries by 11 percent (from 15.4 percent of GDP to 17.1 percent of GDP).

Figure 5.
Figure 5.

Sub-Saharan Africa: Revenue and Expenditure, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.a Excluding external grants.

A breakdown of the various tax categories for both groups of countries is revealing (Table 2). The largest and most broad-based decline in tax revenue in the fixed-rate countries stems from a fall in the taxes on international trade by 2 percentage points of GDP, or a 40 percent decline from its level in 1980–81 (Figure 6). In the variable-rate countries, this tax fluctuated between 5 percent and 6 percent of GDP during the decade, with virtually no change by the end of the decade (5.3 percent of GDP).13

Table 2.

Sub-Saharan Africa: Tax Revenue Performance

(In percentage of GDP)

article image
article image
Source: National authorities and IMF staff estimates.
Figure 6.
Figure 6.

Sub-Saharan Africa: Taxes on International Trade, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Taxes on goods and services in fixed-rate countries have declined throughout the decade (Figure 7). This decline occurred despite concerted efforts at expanding the taxation of domestic transactions by introducing the value-added tax (VAT) and broadening the sales taxes to include services and the distribution sector. Interestingly, Côte d’Ivoire and Cameroon made gains in this tax category, despite the overall downward trend, by broadening their tax bases. In Côte d’Ivoire, taxes on goods and services were maintained at 6.5 percent of GDP over the entire 1987–91 period, despite declines in GDP and per capita income. In the variable-rate countries, this is the tax category in which the most progress was achieved, with the tax ratio rising from 3.8 percent of GDP in 1980 to 5.4 percent of GDP in 1991. The main reason for this progress is the shift of some taxation of international trade to taxation of domestic sales, although the main base of indirect taxation remains imports. When the two tax categories are taken together, the fixed-rate countries have lost 2.3 percentage points of GDP, while the variable-rate countries have gained 0.8 percentage point.

Figure 7.
Figure 7.

Sub-Saharan Africa: Taxes on Goods and Services, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

Income taxes declined in fixed-rate countries by 2.2 percentage points of GDP over the decade, mostly reflecting lower taxes from oil-exporting enterprises following the reverse oil shock in 1986–87. If these oil exporters are excluded, the decline is much lower (0.9 percent of GDP). Nevertheless, at 3.4 percent of GDP in 1990–91, this ratio is particularly low relative to other countries with similar income levels. In the variable-rate countries, excluding Botswana and Nigeria, direct taxes remained remarkably steady during the 1980s (about 4.8 percent of GDP). However, when these two countries are included (Figure 8), there is a gain in direct taxes, reflecting higher oil profits in Nigeria that stemmed partly from the sharp real depreciation of the naira, which more than offset the decline in world oil prices.

Figure 8.
Figure 8.

Sub-Saharan Africa: Income Taxes, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

III. Determinants of Tax Revenue

The stark divergence in fiscal performance between the variable-rate and fixed-rate countries in sub-Saharan Africa raises a number of questions. What are the major factors contributing to the deterioration in revenue performance in the fixed-rate countries, and to the relative success of the variable-rate countries? Why are the major gains and losses concentrated on indirect taxes? To what extent have changes in the real exchange rate affected tax revenue and government expenditures in both groups of countries? Why were the fixed-rate countries unable to reduce their expenditures and conform to the prescriptions of the nominal anchor and the monetary policies of their two central banks? Before addressing these questions, it is important to establish the tax base profile of a typical sub-Saharan country.

Tax Base

An analysis of the major components of the tax base in selected African countries—Cameroon, Côte d’Ivoire, Kenya, Mali, and Tanzania— reveals that imports and the formal segment of the traded goods sector constitute the overwhelming share of the tax base in sub-Saharan Africa (Table 3). In this sample, imports, exports, and the formal import substitution sector would account for 78 percent to 85 percent of tax revenue. As was mentioned earlier, “nontax revenue” mostly reflects implicit taxation of exports (particularly oil and other natural-resource exporters) and to a lesser extent taxation of imports through price stabilization funds.14

Table 3.

Tax Base in Sub-Saharan Countries

article image
Source: Data from country authorities and IMF staff estimates.

Of total sales tax proceeds of CFAF 58 million, CFAF 10 million were collected from the informal sector.

Includes water charges of CFAF 18 million.

Of which, CFAF 34.2 million is tax that is withheld from government employees.

Imports constitute the largest segment of the tax base.15 They are either taxed directly through customs or indirectly through sales taxes and excises. Broad-based sales taxes often yield more revenue from imports than from domestic transactions. In Mali, the VAT on imports produced more revenue in 1991 (12 percent of total revenue) than the VAT on domestic transactions (8 percent). In Côte d’Ivoire, it yields 16 percent of tax revenue as opposed to 14 percent on domestic transactions. In The Gambia, the sales tax on imports generates 32 percent of total revenue, while the sales tax on domestic transactions accounts for only 8 percent. Those taxes on goods and services that are not imposed on imports are mostly levied on import substitutes manufactured domestically. They are concentrated on large manufacturing enterprises because they offer proper bookkeeping and well-defined tax collection points, which tax administrations can monitor easily, as opposed to the fragmented and elusive retail sector.16 On the other hand, small-scale manufacturing (furniture, leather products, and cottage industries) tends to escape the tax net. Income taxes are also mostly levied on large enterprises in the import substitution sector, either as corporate income tax or as an individual income tax withheld by these enterprises from the salaries and wages of their employees.

The nontraded goods sector (mostly government, services, domestic trade, and subsistence agriculture) contributes only 10–15 percent of total tax revenue. Government employees, utilities, and banking are the major contributors of tax revenue in this sector, mostly through direct taxes. Sales taxes on domestic services are limited to major utilities, the banking sector, and the largest hotels. Most other services and domestic trade are in the informal sector and escape taxation. Of course, the informal sector contributes tax revenue (customs duties, sales taxes, and excises) through its own spending on consumption goods but the tax collection handles are again either imports or import substitutes.

The bulk of the nontraded goods sector—subsistence agriculture, small-scale manufacturing, and all the services provided by the informal sector—are outside the tax net. Also virtually excluded because of weak compliance and tax administration are the relatively wealthy self-employed professionals (doctors, lawyers, and traders) and property owners. Some registration and license fees are imposed on property owners but, here again, an imported product—motor vehicles—accounts for the bulk of license fees.

Having established that imports, exports, and import substitution in the formal sector constitute the bulk of the tax base in sub-Saharan African countries, we proceed to analyze the major factors that can affect these activities: (i) the terms of trade, (ii) the exchange rate, (iii) inflation, and (iv) efficiency factors—associated with the trade regime, price policy, and tax structure and administration.

Terms of Trade

Declines in terms of trade have a direct price effect on the tax base by affecting the value of imports and exports and an indirect effect by reducing income and changing relative prices.17 While in fixed-rate countries the decline in the terms of trade can be attributed equally to a decline in export prices and an increase in import prices, in most variable-rate countries the increase in import prices is the dominant factor. In contrast to a decline in export prices, which has a negative effect on government revenues by reducing nontax revenue and direct taxes, an increase in import prices has a positive effect on tax revenue by raising the domestic currency value of imports and import substitutes. While the income and price effects may reduce the volume of imports by shifting some of the demand for imports to cheaper import substitutes, the value of imports in relation to GDP may still rise. Depending on the relative impacts of the decline in export prices and the increase in import prices, a deterioration in the terms of trade can have a positive effect on the tax base. If explicit and implicit export taxation tend to be low relative to import taxation, as in the sub-Saharan countries, the positive price effect may clearly dominate.

In fixed-rate countries, export unit values in U.S. dollars fell an average 22 percent over the 1980s, while in variable-rate countries they fell by only 5 percent, although countries reliant on coffee exports (Burundi, Rwanda, and Uganda) experienced a much sharper decline. While these reductions have mostly affected nontax revenues—and have indirectly affected tax revenues through their negative income effect—both groups of countries have had virtually the same rate of increase in import unit values—about 20 percent—over the decade. Thus, while the price effect of the terms of trade decline appears equally favorable for the tax base in both country groups, the negative income effect is more severe in the fixed-rate countries.

Exchange Rate

Changes in the nominal exchange rate will affect both the unit value of imports and the GDP deflator. A depreciation of the exchange rate would tend to raise import unit values relative to the GDP deflator, and vice versa. It will also tend to increase the unit values of import substitutes and exports relative to nontraded goods. Therefore, a depreciation of the domestic currency tends to increase tax revenue from the traded goods sector in relation to GDP. This price effect may have a negative impact on the volume of imports but a positive impact on domestic production of import substitutes and on tax revenue—both direct and indirect. As already noted, the tax base is heavily weighted toward both imports and import substitutes. In addition, by raising producer prices of exportables, real depreciation would moderate the negative impact of a decline in international commodity prices on the income of the export sector and its demand for tradables.

While changes in the terms of trade or in the nominal exchange rate may have a positive effect on the tax base, what really matters is how these changes are transmitted to the domestic economy through changes in the real exchange rate and other macroeconomic policies. The interplay between terms of trade developments and the nominal exchange rate will determine critical components of the tax base: import unit value, import unit value relative to the GDP deflator, import volume, import composition, the ratio of import duties to imports (the effective import duty rate), and income generated by the traded goods sector.

Import Unit Value and the GDP Deflator

The evolution of the relationship between the terms of trade and the real exchange rate in fixed-rate and variable-rate countries is shown in Figure 9. In the fixed-rate countries, while the terms of trade remained roughly stable in the first half of the 1980s, the CFA franc depreciated substantially vis-à-vis the U.S. dollar, bringing down the real effective exchange rate by about 13 percent, with the result that the import unit value in CFA francs actually increased. However, there was a substantial decline in import volume in the fixed-rate countries (20 percent), particularly when oil exporters are excluded (44 percent). Consequently, tax revenues for the fixed-rate countries remained roughly stable during that period but registered a decline when oil producers were excluded (Table 4).

Figure 9.
Figure 9.

Sub-Saharan Africa: Real Effective Exchange Rates and Terms of Trade, 1980–91 (1985=100)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: World Economic Outlook data base and IMF staff estimates.a Foreign currency is in per unit of domestic currency; trade weights are adjusted for informal trade with The Gambia, Ghana, Nigeria, and Zaire.
Table 4.

External Sector Determinants of Tax Revenue

article image
Source: Data provided by national authorities, IMF staff estimates, and World Economic Outlook data base.

After 1985, the terms of trade took a turn for the worse, declining by about 30 percent, mostly as a result of a fall in export prices. The 1987 reverse oil shock caused a marked deterioration in the fiscal revenues of Cameroon, the Congo, and Gabon. Yet, the real exchange rate moved in the opposite direction by appreciating sharply in 1986 and 1987 and maintaining much of the appreciation for the remainder of the decade (top panel of Figure 9). For the fixed-rate countries, this acted as a second external shock since this appreciation was caused by the strengthening of the French franc vis-à-vis the U.S. dollar, and indirectly by the strengthening of the German mark. By 1990–91, the two largest economies in the franc zone, Côte d’lvoire and Cameroon, incurred the highest real appreciation (36 percent and 32 percent, respectively) followed by Benin (22 percent). This currency appreciation has been a major contributor to the decline in import unit values in the fixed-rate countries, when measured in CFA francs, and in the difficulties experienced by the import substitution sector, particularly the formal manufacturing sector. Interestingly enough, while imports became relatively cheaper because of the appreciation of the CFA franc, the volume of imports actually declined—as discussed below—because of the income effects in the export and import substitution sectors.

Another factor contributing to the decline in import unit values in both domestic and foreign currencies was a change in the composition of recorded imports, typically induced by recessionary conditions, toward basic necessities and lower value items. For instance, food imports have increased as a share of total recorded imports in fixed-rate countries, and there has been a tendency to replace higher priced imports by cheaper imported substitutes (for example, used cars instead of new ones). In Cameroon, products bearing high customs duties fell from 35 percent of imports in fiscal year 1985/86 to 28 percent of imports in 1990/91.18 This may also reflect the tendency since 1985 for a larger proportion of such imports—by Benin, Cameroon, and Niger, in particular—to have originated unrecorded from Nigeria and other non-CFA neighboring countries. This drives down the average effective duty rate on imports since basic necessities, raw materials, and intermediate products bear lower customs duties (and sales taxes) than consumer goods.

Thus, the appreciation of the CFA franc combined with changes in the composition of recorded imports has reduced import unit value in CFA francs by about 15 percent in the fixed-rate countries during the second half of the 1980s. Despite a substantial increase in import prices in foreign currency, the ratio of import unit values to the GDP deflator—which was roughly stable during the 1980–85 period—has also declined by about 7 percent in the second half of the 1980s (Table 3). However, the GDP deflator understates the price relationship between nontraded goods and imports—as well as import substitutes—to the extent that it also includes export prices. Indeed, a fall in export prices raises the ratio of import unit value to the GDP deflator by depressing the denominator, as was the case in Côte d’Ivoire and Gabon, where export prices fell more than import unit values. On the other hand, countries that did not experience a sharp decline in relative export prices—Mali, Senegal, and Togo—have had a large decline in the price of imports relative to the GDP deflator, ranging from 20 percent for Togo to 45 percent for Senegal.

In the variable-rate countries, the real exchange rate followed terms of trade developments more closely (bottom panel of Figure 9). During the first half of the decade, it appreciated by 13 percent, parallel with a similar improvement in the terms of trade, causing import unit values to decline. Since 1985, while the terms of trade deteriorated by 17 percent, the average real depreciation reached 20 percent, and there was no evidence of a change in the composition of imports. Thus, while the ratio of import unit values to the GDP deflator was stable during the first half of the decade, it increased by an average 70 percent during the second half of the 1980s. The largest increases occurred in countries where currencies depreciated rapidly—Madagascar, Nigeria, Uganda, and Tanzania.

Import Volume and the Import-to-GDP Ratio

The divergent trajectories of the real exchange rate and terms of trade in the fixed-rate countries have severely undermined the competitiveness of the traded goods sector and growth performance. Cocoa and coffee producer prices were reduced by more than half in nominal terms in Cameroon, Côte d’Ivoire, and Togo, falling in some cases below production costs. Export proceeds from mineral products (oil in Cameroon, Gabon, and Congo, uranium in Niger, phosphates in Togo) declined sharply with an immediate impact on government revenue from lower royalties and income taxes.

The second half of the 1980s also coincided with import liberalization, which lowered customs tariffs and relaxed quantitative restrictions in fixed-rate countries. While more imports may have contributed to customs duties receipts, they nevertheless exposed the import substitution sector to stiffer competition at a time when domestic demand was falling because of exchange rate appreciation. Moreover, both Nigeria and Zaire sharply depreciated their currencies in real terms, which heightened the competitiveness of their traded goods sectors, causing substantial market penetration in the fixed-rate countries. Overall, the growth of real GDP in these countries declined from 3 percent during the first half of the 1980s to 1.2 percent during the second half, with a concomitant decline in per capita income (Table 5). In contrast, the annual growth rate in variable-rate countries rose from 2.1 percent to 3.6 percent during 1986–91.

Table 5.

Macroeconomic Indicators

(Average annual rate in percent)

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Source: World Economic Outlook data base and IMF staff estimates.

Finally, the decline in the competitiveness of the traded goods sector in fixed-rate countries has resulted in an expansion of the informal sector, further undermining the tax base. Under an overvalued exchange rate, the incentives to operate in the informal sector become particularly strong. On the supply side, moving into the informal sector improves a producer’s competitiveness by avoiding the costs associated with the formal sector’s regulatory framework, import duties and other taxes, license fees, and labor regulations. On the demand side, the consumption pattern shifts toward cheaper substitutes, mostly unrecorded imports from Nigeria and Zaire, offered by the informal trading sector. One indicator of the expansion of the informal sector is the export of CFA francs to neighboring countries—Nigeria, Zaire, Ghana, and The Gambia—in exchange for goods. These currency notes are then remitted to Europe (mainly through London) and repurchased by the central bank in France.19 Such repurchases, which can be interpreted as the net trade balance of the informal sector with more competitive neighboring countries, increased from less than FF 5 billion in 1985 to a peak of FF 12 billion in 1992.20

In the 1970s, the volume of imports rose steadily in sub-Saharan Africa in the wake of the commodity price boom and external borrowing, making up for any occasional decline in import unit values. But with the collapse of export prices and the need to undertake fiscal retrenchment, the demand for imports—both public and private—declined. Despite the favorable price effect of the CFA franc appreciation, recorded imports in the fixed-rate countries declined throughout the 1980s (particularly during the second half of the decade), falling by 1991 to 70 percent of the import volume of 1980. In the variable-rate countries, import volume also declined during the first half of the decade by 23 percent but increased during the second half by a similar magnitude, with the result that, by 1991, import volume was about the same as in 1980. As a percentage of GDP, import volume declined for both groups of countries during the first half of the decade. However, during the second half, variable-rate countries maintained their import shares, while fixed-rate countries incurred a 20 percent decline.

The combination of the changes in import prices in local currency, import volume, and the composition of imports determines a critical component of the tax base, namely the value of recorded imports in relation to GDP. In the fixed-rate countries, recorded imports declined from 29 percent of GDP in 1980–81 to 19 percent of GDP in 1990–91, with the downward trend accelerating after 1985 (Table 4). This shrinkage in the tax base by 10 percentage points of GDP on the import side and a concomitant decline in the production level of the formal import substitution sector—instead of a resurgence in import substitution under adequate exchange rate protection—go a long way in explaining the weakening of tax revenue in the fixed-rate countries.

Variable-rate countries also experienced a reduction in their imports in relation to GDP during the first half of the decade, very much in line with the fixed-rate countries (from 28 percent to 25.5 percent of GDP). However, with the real exchange rate depreciation that took place after 1985, imports increased to 32 percent of GDP by 1990–91. Thus, variable-rate countries were able to broaden this critical tax base—the imports to GDP ratio—over the 1980s.21

Efficiency Factors

In addition to the macroeconomic factors outlined above, tax revenue has been affected by discretionary government policy and the institutional changes carried out over the past decade under structural adjustment programs supported by the IMF and the World Bank. In most sub-Saharan African countries, there has been an attempt to improve overall efficiency by allowing the market to determine prices and dictate most investment decisions, rather than following the failed industrial strategy of the 1970s. In the fiscal area, this approach has entailed broadening the tax base, deregulating prices, lowering external tariffs, liberalizing imports, shifting the taxation system toward domestic transactions, and reforming the income tax. It is difficult to measure the overall impact of these reforms on tax revenue, but they tend to reduce distortions and create an enabling environment for investment and higher growth.

Governments have also resorted to ad hoc fiscal measures to relieve the economic pressures experienced in the 1980s. Additional taxes (such as an import surcharge or solidarity tax) or increases in tax rates have frequently been introduced after a widening of the fiscal deficit. Such pressure has been manifest in fixed-rate countries that needed to mobilize additional resources to finance their budget deficits. A case in point in Côte d’lvoire, which in 1987 and 1988 increased its import tariffs by 10 percent, increased excise taxes on tobacco, and increased stamp duties, license fees, and vehicle registration fees. Indeed, some doubts may be raised on the quality of adjustment in this case, since raising government revenues by increasing tax rates, given the concomitant narrowing of the tax base, cannot be sustained and may follow a Laffer curve scenario.

There were also pressures in the opposite direction, mostly in response to financial difficulties experienced by enterprises in import substitution activities, which resulted in lower average effective rates and a further narrowing of the tax base. Such tax relief included granting tax exemptions, allowing the build-up of tax arrears, and granting generous tax holidays. Fixed-rate countries have been particularly prone to these tendencies, with acute competitive pressures arising from the appreciation of the CFA franc and from the real currency depreciation in some neighboring countries. Thus, it has been estimated that roughly half of the imports into fixed-rate countries have been exempted from customs duties for various reasons, including generous provisions under investment codes. The proliferation of exemptions has reduced the average effective customs tariff, as measured by the ratio of receipts from import duties to total recorded imports, to less than half the statutory rate for the seven members of the West African monetary union.22

Another factor that has contributed to the narrowing of the import tax base is the growing importance of donor-financed imports, which are tax exempt. This has affected both country groups in a similar fashion. After the debt crisis, there has been a significant shift in project financing away from commercial sources, which paid full customs duties, to official bilateral and multilateral donors, which expect to be fully tax exempt for foreign assistance. Some of the changes in the import tax base can be traced to the average effective tariff. In the early 1980s, the average effective tariff in fixed-rate countries was 22 percent, substantially higher than in the variable-rate countries (15 percent). Despite efforts at broadening the taxation of imports (through the imposition of a minimum tariff), the effective tariff fell to 20 percent, mostly because of tariff reform, changes in the composition of imports, and the broadening of exemptions. In the variable-rate countries, many of which started off with a very low tariff base in the early 1980s (Tanzania, Zambia, and Uganda), the average effective import tariff rose from 15 percent in 1980 to 18 percent in 1990–91.

Impact of Inflation on Tax Revenue

In addition to the exchange rate, other components of the macroeconomic mix can also have a significant impact on tax revenue. In particular, when inflationary policies are pursued by the government—through expansionary fiscal policies, monetization of the budget deficit, and frequent devaluations—tax revenue can be affected negatively in various ways. Collection lags, the effects of maintaining specific excise taxes, administered prices for basic commodities and utilities, and declines in real interest rates toward negative levels are among the factors that erode the real value of the tax base and contribute to widening the fiscal deficit (Tanzi (1977)). An empirical overview of the relationship between inflation and tax revenue in sub-Saharan Africa confirms that tax revenue has declined in countries where there have been sharp accelerations of inflation (such as Uganda, Zambia, and Zaire). However, for the remainder of the variable-rate countries, the level of inflation—the persistence of inflation in the 15–20 percent range, as opposed to 2 percent in the fixed-rate countries—did not seem to affect tax revenue significantly.

Average inflation in the variable-rate countries has certainly been higher than in the fixed-rate countries. During the first half of the decade, the inflation rate averaged 24 percent and accelerated to 33 percent during the 1986–91 period, as a result of higher monetary expansion and a substantial real depreciation of the exchange rate in a number of countries. Seigniorage revenue was almost double that of the fixed-rate countries during the first half of the decade (2.1 percent of GDP) and increased to 3.2 percent of GDP during the second half.23 However, within these broad aggregates, one can distinguish two groups of countries. The first group of 11 countries made progress in reducing average inflation from 17 percent during the first half of the 1980s to 13 percent during the second half of the decade (Botswana, Burundi, The Gambia, Ghana, Kenya, Madagascar, Malawi, Mauritania, Mauritius, Rwanda, and Zimbabwe). Their tax revenue increased from 17.8 percent of GDP in 1985–86 to 21.1 percent of GDP in 1990–91. In the remaining six high-inflation countries of the variable-rate sample (Nigeria, Sierra Leone, Tanzania, Uganda, Zaire, and Zambia), inflation accelerated from 40 percent in 1980–85 to 75 percent during the 1986–91 period, with most of the deterioration owing to the sharp price increases in Uganda, Zaire, and Zambia. During the same period, tax revenue in these countries declined from 15.3 percent of GDP to 13.1 percent of GDP. The increase in the tax revenue of the first group of countries, despite persistent inflation at about 15 percent a year, may have to do with the structure of taxation in sub-Saharan Africa and efforts at containing inflationary pressures.

First, most of the consumption taxes levied on these imports and import substitutes are expressed in ad valorem terms, and the remaining specific excises have been gradually converted to an ad valorem basis through tax reforms (as has happened in Burundi, The Gambia, Malawi, Mali, and Mauritania). Moreover, the liberalization of exchange rate policies has ensured that the market exchange rate is the rate at which imports are valued at customs.24 Thus, increases in the prices of traded goods tend to be translated into higher tax revenue with relatively low collection lags, typically within one or two months. Second, interest income, which is particularly sensitive to erosion under inflation and which is a substantial source of taxation in Latin America, does not as yet constitute a significant source of tax revenue in most sub-Saharan African countries. Moreover, the restructuring of interest rates and yields on government obligations in several variable-rate countries (The Gambia, Ghana, Kenya, Malawi, Mauritius, Nigeria, Tanzania, and Uganda) in the 1980s have tended to introduce positive real interest rates (Galbis (1993)).

Third, income taxes, which can be seriously eroded by inflation because of collection lags, account for the lowest share of tax revenues and have been reformed in a number of countries. Corporate income tax rates have been lowered and collection lags have been reduced by levying tax payments monthly or quarterly on expected income in the current year rather than on the income of the previous year (Kenya and Malawi). The individual income tax, which is mostly levied on wages in the formal sector, is withheld at source and is not eroded by inflation. On the other hand, lowering marginal tax rates toward the 35–40 percent level and raising the standard deduction with inflation have minimized the fiscal drag. These factors have enabled the variable-rate countries to maintain the ratio of direct taxes to GDP over the entire 1980–91 period (at 4.8 percent of GDP) despite the high inflation environment.

IV. Public Expenditure

In our full sample of 28 countries, public expenditures have remained remarkably steady at about 28 percent of GDP between 1980 and 1991. But as in the case of the overall budget deficit, the expenditure pattern of the two groups of countries is quite different.

Expenditure Policy in Fixed-Rate Countries

Under the internal adjustment strategy, major policy requirements for maintaining a pegged exchange rate as a nominal anchor are that governments conduct fiscal policy in such a way that (i) the budget deficit is reduced to a level that makes demand for foreign exchange consistent with the pegged exchange rate and (ii) the relative prices between traded and nontraded goods can change in response to protracted external shocks so as to maintain competitiveness.

It is useful to recall that since 1985 the double impact of the deterioration of the terms of trade and the appreciation of the CFA franc resulted in a substantial decline in the competitiveness of the traded goods sector. In the face of this external shock, fiscal and monetary policies are called upon to lower real wages—and the prices of nontradables—so that the costs of producing traded goods decline sufficiently to restore their profitability. In most CFA countries, this would have entailed lowering nominal wages since inflation had already been reduced to very low levels. Since most tax revenue originates from imports and the traded goods sector, the drop in competitiveness has lowered tax revenue and contributed to a widening of the fiscal deficit. Here lies the essential contradiction of the internal adjustment strategy: the real appreciation of the exchange rate, by undermining competitiveness, reduces tax revenue, which widens the fiscal deficit. Yet this expansionary fiscal impulse goes against the contractionary fiscal policy needed for lowering real wages. Hence, expenditure policy is called upon not only to reduce the deficit and change relative prices but also to make up for the decline in tax revenue.

Despite the need to reduce the large fiscal deficits that emerged at the beginning of the 1980s, public expenditures in the fixed-rate countries have actually increased during the first half of the decade from 27.9 percent of GDP in 1980–81 to about 29.4 percent of GDP in 1985–86 (Table 6 and Figure 10). Since tax revenue was declining during the period, fiscal discipline would appear to have been relaxed in many fixed-rate countries, with costly consequences for the second half of the decade. During the 1986–91 period, with the further decline in tax revenue, the emergence of payment arrears, and the tightening of monetary policy, government expenditures were reduced to 25.3 percent of GDP by 1990–91. This major expenditure effort, equivalent to almost 4 percentage points of GDP, is particularly noteworthy considering that GDP was also declining and that there is usually little short-run policy flexibility in reducing current expenditures. Indeed, this decline was mostly attained by cutting capital expenditures. Subsequently, when restoring competitiveness required a reduction in current expenditures (by reducing wages), these expenditures actually increased from 17.4 percent of GDP in 1985 to 18.2 percent of GDP in 1990–91 (Figure 11).

Table 6.

Expenditure Performance

(In percentage of GDP)

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Source: National authorities and IMF staff estimates.
Figure 10.
Figure 10.

Sub-Saharan Africa: Total Expenditure, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.
Figure 11.
Figure 11.

Sub-Saharan Africa: Current Expenditure, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

As a rough order of magnitude, balancing the budgets of the fixed-rate countries (including grants) by the end of the 1980s would have required a fiscal retrenchment of 6 percent of GDP.25 At least half of this amount would have had to come from reducing wages to the average level in variable-rate countries, in an attempt to lower the prices of nontradables. Actually, the budgetary wage bill in fixed-rate countries (in relation to GDP) rose by 17 percent between 1980 and 1991 (Figure 12).26

Figure 12.
Figure 12.

Sub-Saharan Africa: Expenditure on Wages and Salaries, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

The government wage bill in the fixed-rate oil-exporting countries (Cameroon, Congo, and Gabon) continued to grow from 6.4 percent of GDP in 1980–81 to 10.3 percent by 1990–91 (Table 6), partly through increases in salaries and partly through an expansion in the size of the civil service, in order to staff the large infrastructure created in the early 1980s. Again, this reflects lax financial discipline within the two monetary unions, since this increase coincided with an accumulation of domestic and external arrears. In contrast, the non-oil countries made early efforts to reduce the wage bill, from 8.4 percent of GDP in 1980–81 to 7.6 percent in 1985–86. These efforts were maintained in the second half of the decade, but the fall in real GDP was larger than the nominal reductions in the wage bill, with the result that the share of wages in GDP rose from 7.6 percent in 1985–86 to 8.3 percent of GDP in 1990–91. This underscores the political difficulty faced by fixed-rate countries in reducing nominal wages and public employment under recessionary conditions.

The difficulties in exercising expenditure restraint in fixed-rate countries were exacerbated by a doubling of interest costs, from 2 percent of GDP in the early 1980s to 4 percent of GDP by the end of the decade. It should be noted, however, that this interest cost understates the full interest cost that would have been incurred by fixed-rate governments in the presence of functioning financial markets. Indeed, there are various forms of debt incurred by these governments—domestic payment arrears and arrears on social security contributions—on which no interest has been paid or budgeted.

The rise in both interest and wages in relation to GDP inevitably squeezed expenditures on goods and services and transfers. These were reduced from 7.1 percent of GDP at the beginning of the 1980s to 5.6 percent of GDP in 1990–91. This reduction has affected budgetary transfers to enterprises and consumers, although they have been relatively small in fixed-rate countries. But, more seriously, expenditures on schools, health facilities, and government administrations (including vehicles for tax administration) have been sharply cut in some countries and may have led to a deterioration of the infrastructure and the services provided by the government. This type of fiscal adjustment can be temporary only and would eventually require the restoration of expenditures on goods and services to a more sustainable level. It suggests that the underlying budget deficit in the fixed-rate countries during the 1988–91 period may be larger than the measured deficit.

The increase in current expenditures in the fixed-rate countries, concurrent with the sharp decline in revenue and the financing difficulties experienced in the 1985–91 period, forced substantial cuts in public capital expenditures. After increasing during the first half of the decade, they were reduced by almost half, from 11.5 percent of GDP in 1985–86 to 6.1 percent in 1990–91 (Figure 13). In some countries, this reduction proved beneficial, as it eliminated unproductive or marginal investments; in other countries (Congo, Côte d’Ivoire, and Senegal) gross capital expenditures were reduced to 2–3 percent of GDP, which may have resulted in a net reduction of the capital stock.

Figure 13.
Figure 13.

Sub-Saharan Africa: Capital Expenditure, 1980–91

(As percent of GDP)

Citation: IMF Staff Papers 1994, 001; 10.5089/9781451957037.024.A004

Sources: National authorities and IMF staff estimates.

Expenditure Policy in the Variable-Rate Countries

In the variable-rate countries, total expenditures declined throughout the 1980s from about 28.3 percent of GDP in 1980–81 to 26.7 percent of GDP in 1990–91. As in the case of the fixed-rate countries, most of this adjustment can be attributed to a reduction in capital spending. However, in contrast to the fixed-rate countries, current expenditures remained virtually stable throughout the decade at 19.3 percent of GDP. If interest costs are excluded, however, current expenditures fell by 2.5 percent of GDP between 1980–81 and 1990-91.

In contrast to the fixed-rate countries, the wage bill in the variable-rate countries declined from 6.9 percent of GDP in 1980–81 to about 6 percent of GDP in the mid-1980s (and marginally thereafter), ending the decade at 5.8 percent of GDP, or about one-third lower than the wages-to-GDP ratio in the fixed-rate countries. Much of this decline resulted from lags in nominal wage adjustments behind price increases. Policies of active exchange rate depreciation in the variable-rate countries have succeeded in reducing real wages.

A reduction in real wages was needed to accommodate the sharp increase in interest costs from 1.8 percent of GDP in 1980–81 to 4.3 percent of GDP in 1990–91. It is interesting to note that, by the end of the decade, despite very substantial real exchange rate depreciation, the interest burden in the variable-rate countries in relation to GDP was only marginally higher than interest expenditures in the fixed-rate countries (4.3 percent of GDP versus 4.1 percent of GDP), even though the two groups of countries started off the decade with similar interest charges. In particular, during the second half of the decade, when the depreciation of the real exchange rate was at its highest, the interest burden hardly changed. Yet it is a common criticism of an active exchange rate policy that servicing of the public external debt escalates, resulting in a deterioration of the budget. Three factors have contributed to this outcome. First, the widening of fiscal deficits in the fixed-rate countries over the decade raised interest costs, while the opposite occurred in the variable-rate countries. Second, the poor growth record of the fixed-rate countries has reduced GDP, while the better growth record of the variable-rate countries has increased it. Third, there was significant capitalization of interest through debt rescheduling and, particularly since 1987, through the lengthening of maturities, the partial cancellation of debt, and concessions on interest rates. This may have benefited the variable-rate countries to a greater degree than the fixed-rate countries. Because the variable-rate countries are generally poorer than the fixed-rate countries, they benefit more from favorable rescheduling terms, including debt cancellation. Moreover, the interest burden becomes endogenous to the adjustment process when reducing the fiscal deficit and undertaking structural changes facilitate debt rescheduling; adjustment may also provide greater concessionality in foreign financing.27 However, a greater degree of debt rescheduling, coupled with an active exchange rate policy, would also result in a larger stock of debt. Indeed, the ratio of external debt to GDP in the variable-rate countries doubled over the decade to 107 percent of GDP in 1986–1991 (Table 5).

There was also a reduction in government expenditures on goods and services, which declined in the variable-rate countries from 10.5 percent of GDP in 1980–81 to 9.3 percent by 1985–86, remaining stable at that level for the remainder of the decade. By 1990–91, expenditures on goods and services as a percent of GDP were 3 percentage points above their level in fixed-rate countries.

Capital expenditures were also reduced in the variable-rate countries, mostly during the first half of the decade (from 8.7 percent of GDP to 6.4 percent of GDP), and were raised to a lesser extent during the remainder of the decade. Hence, during the second half of the decade, when the decline in the terms of trade was its worst, expenditure reduction in the variable-rate countries was broadly distributed, while in the fixed-rate countries it was concentrated in lower spending on goods and services and on capital investment.

V. Summary and Conclusions

Fiscal adjustment in sub-Saharan Africa during the 1980s has been difficult. A protracted decline in the region’s terms of trade and falling per capita income have clouded the political climate in most countries and surrounded any adjustment strategy with substantial risks. Seen from this perspective, the improvement in the fiscal performance of most sub-Saharan countries is particularly noteworthy. Nevertheless, opportunities for adjustments and consolidation of stabilization efforts have been missed.

During the first half of the decade (1980–85), the real exchange rate depreciated in the fixed-rate countries by about 15 percent in conjunction with a small improvement in the terms of trade. This provided an opportunity for fiscal retrenchment, and the fixed-rate countries were able to improve their revenue performance from 21 percent to 22 percent of GDP. However, because they were reaching the upper limits of revenue increases, the burden of adjustment fell squarely on expenditures. Yet, the oil-producing fixed-rate countries continued to increase capital expenditure in relation to GDP, offsetting revenue gains and widening their deficits. And while the other fixed-rate countries managed to reduce their fiscal deficit marginally (from 10.5 percent of GDP to 9.5 percent of GDP), this was clearly inadequate to restore domestic balance and consistency between monetary and fiscal policy. In the variable-rate countries, while government revenue in relation to GDP hardly changed (18.2 percent of GDP), there was a major effort on the expenditure side, which reduced the deficit from 11 percent of GDP to 7 percent of GDP, notwithstanding a doubling of interest costs.

During the second half of the decade, the terms of trade deteriorated sharply in the fixed-rate countries (by 30 percent) while the real effective exchange rate appreciated by about 10 percent. The combined impact of these two external shocks, coupled with import liberalization and lower trade tariffs, weakened the traded goods sector by reducing the competitiveness of both exports and import substitutes. This undermined the tax base, as indicated by a fall in the import-GDP ratio from 27 percent to 21 percent. Falling incomes in the export and manufacturing sectors, cheaper imports, lower volume of recorded imports, and an expansion of the informal sector reduced budgetary revenue in fixed-rate countries by 4.3 percentage points of GDP, a major deterioration considering that it occurred over a span of only five years and that GDP was stagnant.

The policy response to the fall in tax revenue and the rising interest burden has been to increase tax rates, reduce public spending on goods and services, cut investment expenditures, and finance the fiscal gap through foreign borrowing, grants, and accumulation of domestic and external payment arrears. Increases in tax rates and resorting to domestic payment arrears have weakened the formal traded goods sector and strengthened the informal sector, further contributing to a narrowing of the tax base and to a deterioration of tax compliance. While adjustment should have occurred through lower civil service wages and employment, the wage bill actually increased in relation to GDP. Moreover, some of the expenditure cuts—particularly in operations, maintenance, and supplies—may have been counterproductive and unsustainable.

The decline in the terms of trade in the variable-rate countries during 1986–91 was more moderate than in the fixed-rate countries (20 percent versus 30 percent) and was fully matched by a reduction in the real effective exchange rate. This helped to increase the import ratio in variable-rate countries (from 26 percent of GDP to 29 percent of GDP), thereby protecting the tax base and raising revenue. However, the momentum of reducing expenditure stalled during the second half of the decade at about 26 percent of GDP. Even in the 11 countries undergoing sustained adjustment efforts, inflation remained imbedded at the two-digit level because of insufficient fiscal retrenchment and expansionary monetary policy. Nevertheless, by the end of the decade, the government wage bill in the variable-rate countries was one-third lower than the wage bill in the fixed-rate countries, and the primary deficit was further reduced to 1.4 percent of GDP (from 9 percent in 1980–81), which is the most telling indicator of fiscal adjustment in variable-rate countries.

Drawing on the fiscal experience of the two country groups analyzed in this study, a number of policy-oriented findings can be highlighted.

—A major factor in the deterioration of fiscal performance in the fixed-rate countries during the second half of the 1980s was that the real exchange rate increasingly diverged from its equilibrium path. Conversely, the variable-rate countries were able to improve their fiscal performance, despite their expansionary monetary policies, because their real exchange rate was converging toward its equilibrium path. Thus, while using a fixed exchange rate as a nominal anchor can have major advantages in limiting monetary expansion and ensuring price stability, it can contribute to the attainment of other macroeconomic objectives—particularly fiscal balance, competitiveness, and growth— only if it is adjusted in response to protracted external shocks.

—Because the tax base in sub-Saharan Africa is so heavily concentrated on the imports and import substitutes of the modern traded goods sector, protecting the competitiveness of that sector is essential for the preservation of tax revenue. Attempts at restoring the fiscal balance and competitiveness by wage deflation may be partly self-defeating and, given the magnitude of the required adjustment, unrealistic. It is self-defeating in the sense that an overvalued exchange rate, by undermining tax revenue, leads to a widening of the deficit and an expansionary fiscal impulse, when what is required under internal adjustment is a contractionary policy. An internal adjustment based on a fixed exchange rate strategy would require not only a major decline in nominal wages, a politically difficult undertaking under any circumstance, but one of such a magnitude as to offset the decline in government revenue triggered by the erosion of the tax base. Even if such a strategy were feasible, the cost in forgone output would be considerable. Under these circumstances, it would be very difficult for fiscal policy to serve as a proxy for exchange rate policy. Rather, exchange rate policy and fiscal policy should be viewed as complementary. An inappropriate exchange rate policy undermines the ability of the fiscal authorities to attain fiscal balance, let alone competitiveness. Thus, presenting the internal and external adjustment strategies as two alternatives is not realistic for policy purposes.

—The transmission mechanism between the reduction in the budgetary wage bill and an increase in competitiveness—say, for export crops—is not clear in the institutional set-up of sub-Saharan countries. Non-market-clearing wages can persist despite substantial unemployment because of the dual structure of the labor market: the formal sector, which is influenced by union and political power, and the informal one, in which the implicit wage in the agricultural subsistence sector can act as a floor. More work needs to be done on wage determination in African countries before wage deflation is the recommended policy for changing relative prices.

—The variable-rate countries as a group did not reduce their real exchange rate during the second half of the decade beyond the deterioration in their terms of trade. While individual countries may have pursued a more active exchange rate policy, these countries did not resort—as a group—to “beggar thy neighbor” policies. Nevertheless, there is a need for regional surveillance of macroeconomic policies in Africa and the establishment of a behavioral framework within which outlier countries can be monitored.

—Fiscal discipline in the fixed-rate countries, as implied by the statutory arrangements of the western and central African monetary unions, was insufficient for the smooth operation of this regime. When faced with major fiscal gaps, the fixed-rate countries found it difficult to reduce current expenditures, particularly nominal wages. Instead, a variety of ways were found to finance these gaps, including the build-up of domestic and external arrears, the use of social security funds, and the circumvention of the statutory limits on government borrowing by drawing on credit extended to parafiscal agencies (such as stabilization funds) or resources available to public enterprises, particularly those processing mineral deposits (such as oil in Cameroon, Gabon, and the Congo, and phosphates in Togo).

—The rules followed by the two regional banks in West Africa in determining credit to the government (the use of the previous year’s fiscal revenue as a measure of creditworthiness) may have exacerbated fluctuations in income. Considering that fiscal revenues are closely related to terms of trade and exchange rate movements and depend on a narrow range of exports, other credit rules may need to be considered. In particular, if government expenditure were appropriate, a credit rule based on a small real yearly increase in “core” expenditures may be more justifiable.

—Inflation remains imbedded in most variable-rate countries at the two-digit level, mostly because of frequent devaluations without adequate monetary and fiscal restraint. Such inflationary pressures have persisted, even in those countries that reduced their budget deficits and eliminated bank financing of the deficits. Since external grants have become a major source of deficit financing for most variable-rate countries, there is a need to look into the inflationary pressures that external grants generate and the fiscal stance that would be consistent with their elimination.

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1

The 11 fixed-rate countries in the sample are all members of the CFA franc zone: Benin, Burkina Faso, Cameroon, Central African Republic, Congo, Côte d’Ivoire, Gabon, Mali, Niger, Senegal, and Togo.

2

The 17 variable-rate countries are Botswana, Burundi, The Gambia, Ghana, Kenya, Madagascar, Malawi, Mauritania, Mauritius, Nigeria, Rwanda, Sierra Leone, Tanzania, Uganda, Zaire, Zambia, and Zimbabwe.

3

In terms of GDP, the average investment rate in the 1970s was 20.6 percent in sub-Saharan Africa and 21.6 percent in south Asia.

4

This dependence is defined as taxes on imports and exports, nontax revenue on imports and exports, plus excise taxes, sales taxes, and fees levied on imports as a percentage of total tax receipts.

5

If terms of trade are weighted by each country’s share of trade, the figures are 23 percent for the variable-rate countries and 37 percent for the fixed-rate countries.

6

On January 12, 1994, the CFA franc was devalued from FF 1 = 50 FCFA to FF 1 = 100 FCFA.

7

Another adjustment instrument that has been used by some sub-Saharan African countries is commercial policy. Theoretically, a real devaluation can be approximated through a uniform surcharge on imports and a uniform subsidy on exports (see Devarajan and De Melo (1987)). However, this approach is difficult to implement, partly because of the need to impose subsidies on the value added rather than on the gross value of exports and partly because of substantial unrecorded border trade from non-CFA countries, particularly Nigeria.

8

Although trade with France amounts to a sizable share of CFA franc zone imports and exports, prices of major exports (coffee, cocoa) and imports (petroleum products) are denominated in U.S. dollars.

9

For instance, The Gambia did not drop the peg to the pound sterling until 1986.

10

Simple annual averages across each group have been derived for the fiscal aggregates.

11

The main limitation of this concept is the implicit assumption that all investment is good and all current expenditure (including health, education, operations, and maintenance) is consumption and does not contribute to growth.

12

Nontax revenue, which accounts for about 2 percent of GDP in both country groups, hardly changed in the variable-rate countries and increased by 0.5 percent of GDP in fixed-rate countries.

13

These results, as well as those pertaining to taxes on goods and services, should be interpreted cautiously since tax reforms have tended to lower tariffs and shift taxation to domestic transactions. However, this pattern of tax reform has affected both groups of countries in a similar fashion.

14

In some countries, central-bank profits constitute a sizable share of nontax revenues.

15

Explicit export taxes, which were small in the early 1980s, have been further reduced through tax reform, which has eliminated them in a number of countries. However, when implicit export taxes are added, export taxes can become significant—between 1 percent and 2 percent of GDP.

16

Among the largest contributors of excise and sales taxes are the manufacturers of mass-market goods, such as petroleum products, textiles, shoes, beverages, plastics, cigarettes, fertilizers, cement, and processed foods.

17

When real GDP is adjusted for the decline in the terms of trade, growth of national income can be substantially weaker than the growth of GDP. Thus, in Côte d’lvoire, the cumulative growth of real GDP between 1980 and 1991 was 5.3 percent but, when adjusted for terms of trade changes, real national income fell by 20.6 percent. This may be an extreme example since Côte d’lvoire, with its exports concentrated on cocoa and coffee, has experienced a 56 percent decline in terms of trade between 1980 and 1991. However, other countries, particularly Cameroon, Gabon, Nigeria, Tanzania, and Uganda, have experienced even larger declines, although the effect on national income depends on the relative shares of imports and exports in GDP.

18

These products include cigarettes and tobacco, beverages, furniture, textiles, plastics, glass products, aluminum, vehicles, pesticides, lubricants, electrical machinery, and electrical appliances.

19

These flows should be distinguished from capital movements which are effected mostly through the banking system.

20

See Secrétariat du comité monétaire de la zone franc (several issues). On August 1 and 2, 1993, in reaction to a sharp increase in the outflow of their currency, the 13 CFA franc zone countries suspended the repurchase of their currency notes, in effect partially suspending the convertibility of the CFA franc.

21

The linkages among government revenue, the terms of trade, and the real exchange rate have been tested using panel data over the 1980–91 period. The econometric results, available from the authors, indicate that tax revenue in sub-Saharan Africa is negatively correlated with movements in the real value of the domestic currency: an appreciation of the real exchange rate would yield a fall in the ratio of tax revenue to GDP. It is also negatively correlated with the terms of trade. Here, the positive price effect of an increase in import prices dominates the negative income effect of the terms of trade deterioration. Similar results are obtained when total revenue is used as an independent variable.

23

See World Bank (1994). The literature on optimal taxation has made a case for some degree of seigniorage revenue.

24

Under the dual exchange rate regimes that have been pursued in the past (Nigeria, Tanzania, and Zambia), the official overvalued exchange rate would serve as a basis for customs valuation of imports, resulting in the erosion of this tax base under inflation.

25

As the fiscal deficit is reduced, tax revenue would be expected to fall further in relation to GDP, so that the actual fiscal effort required may be greater than the initial deficit.

26

When the government wage bill in fixed-rate countries is contrasted with some indicators of private sector income, such as producer prices for coffee and cocoa, which were reduced by half during the second half of the 1980s, or with trends in private consumption as estimated by national accounts during the same period, it appears that government adjustment efforts to improve the fiscal balance have lagged well behind those of the private sector (Secretariat du comité monétaire de la zone franc (1992 and other issues)).

27

The same factors may account for a doubling of grants to 3.6 percent of GDP in variable-rate countries over the 1980s, while in fixed-rate countries they declined from 3.2 percent of GDP in 1980–81 to 2.4 percent of GDP in 1990–91.

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Cover IMF Staff Papers
IMF Staff papers, Volume 41 No. 1
Author:
International Monetary Fund. Research Dept.
Volume/Issue:
Volume 1994: Issue 001
Publisher:
International Monetary Fund
ISBN:
9781451957037
ISSN:
1020-7635
Pages:
181
DOI:
https://doi.org/10.5089/9781451957037.024