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Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21–29, 2011 1. Objectives and uses of fiscal policy Stabilization, allocation, distribution 2. Global financial crisis and fiscal policy response Benefits and risks related to fiscal policy Public debt dynamics Sustainability of public debt Safeguarding fiscal sustainability Exit strategies when things go wrong 3. Fiscal reforms 1. The term fiscal policy refers to the use of public finance instruments to Vito Tanzi influence the working of the economic system to maximize economic welfare 2. Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing 3. Assessing the stance of fiscal policy requires taking account of the activities of all levels of government 1. Stabilization Fiscal policy influences aggregate demand Directly because Y = C + I + G + X – Z Indirectly because C depends on income after tax Through demand, fiscal policy affects output, employment, inflation, balance of payments 2. Allocation Fiscal policy also influences aggregate supply Public infrastructure, education, health care 3. Distribution Through taxes, transfers, and expenditures Progressive, neutral, regressive Fiscal policy can be used to several ends To achieve internal balance By adjusting aggregate demand to available supply By achieving low inflation, potential output To promote external balance By ensuring sustainable current account balance By reducing risk of external crisis To promote economic growth E.g., through more and better education and health care Fiscal policy needs to be coordinated with monetary, exchange rate, and structural – i.e., supply-side – policies Demand management E.g., lower income taxes Aggregate supply in short run Price level B A Aggregate demand Output Demand management Supply management E.g., lower income taxes E.g., lower import tariffs Aggregate supply in short run Aggregate supply in short run Price level Price level B A A Aggregate Aggregate B demand demand Output Output Y = GDP C = Consumption I = Investment G = Government expenditure (plus lending minus repayments) T = Taxes (plus grants) National income accounts X = Exports Z = Imports Y=C+I+G+X–Z B = Government bonds outstanding DG = Credit from banking system S = Y – T – C = I + G – T + X – Z, so DF = Credit from foreigners G–T=S–I+Z–X Government budget deficit must be financed either by (a) having private saving in excess of private investment or (b) by accumulating foreign debt through a deficit in the current account of the balance of payments, or both Alternative formulation Inflationary v s. finance G – T = D B + D DG + D DF no ninflationary Government budget deficit must be financed by borrowing either at home or abroad, i.e., from (a) the public, (b) the banking system, or (c) foreigners Central bank financing involves money creation Inflation tax: Most inflationary form of financing tax Bond finance is less inflationary Removes financial resources from circulation Increases real interest rates Crowds out private investment External financing can be inflationary Especially if it leads to currency depreciation Evidence from cross-country data Strong links between budget deficits and inflation in developing countries, but not in industrial countries Bond finance is the rule in industrial countries … … and money finance is the exception Conventional budget surplus not that T–G Problem here is e but deficit is too larg Large in upswings when tax base (Y) is strong o low that income is to sion Small in downswings when tax base is weak Economic expan ally would automatic surplus, Full-employment surplus turn deficit into n T, G from red to gree FE T –G Use tax revenue as it would be T at full employment Independent of business cycles G A budget in deficit could be in surplus with full employment Deficit can be consistent with a tight fiscal stance (see chart) Y < YFE YFE Y Public sector borrowing requirement Broad measure of public sector deficit, including central, state, and local government Primary budget balance Leaves out interest payments Conventional deficit = G – T = GN + GI – T = GN + iDG - T Primary deficit = GN – T = G – T – iDG GN = Noninterest expenditure GI = Interest expenditure i = Nominal interest rate DG = Government debt outstanding Operational deficit r≈i-p Leaves out inflation component of interest payments Operational deficit = conventional deficit minus inflation component of interest payments = primary deficit plus real component of interest payments Conventional deficit: GN = Noninterest expenditure GI = Interest expenditure G – T = G + iD – T = G + (r + p)D – T N G N G r = Real interest rate Operational deficit: DG = Government debt p = Inflation rate G – T - pDG = GN – T + rDG Hence, operational deficit includes only real part of interest payments, leaves out the inflation part Before Great Depression 1929-39, many thought that governments needed to balance their budgets from year to year Even so, US had built is railways through borrowing, for example Keynes revolted (General Theory 1936) If private sector failed to consume and invest, government could fill the gap Y = C + I + G + X – Z C and I and G appear side by side Guns or butter? Makes no difference Also, could reduce taxes to encourage C and I Multiplier analysis It could be shown that, with unemployed resources, an increase in G would raise Y by an amount greater than the original increase in G Active fiscal policy was used consciously in Sweden even before Keynes … … and adopted in US and elsewhere after 1960 (Kennedy-Johnson administration) Coincided with buildup of US as a welfare state with greater emphasis on public services and social security, like in Europe Active fiscal policy came naturally to Europe Fiscal policy can affect Aggregate demand, output, and price level Cut taxes: Consumption, output, and prices rise Rate of monetary expansion and inflation Increase spending financed by credit expansion: Money expands (M = D + R), so inflation goes up R Aggregate supply and economic growth Boost infrastructure, education, and health care: Efficiency and long-run growth go up Current account of balance of payments Raise taxes: Disposable income and imports fall, so current account improves unless currency appreciates Fiscal multipliers are positive, but small Impact of fiscal policy actions depends on Whether economy is open or closed (import leakage) Exchange rate regime (fixed or floating) Type of budget financing (money creation or debt) Degree of confidence in economic policy Level of government debt outstanding Financing constraints Risk premia on debt Whether fiscal changes are considered temporary or permanent How close the economy is to full employment this Will return to (-) RE Gov’t Budget (+) (-) Consumption Balance (+) (+) (-) (+) Tax (+) (+) revenue Expenditure Income Interest Rate (+) (-) (-) Investment Fiscal Policy (+) (+) Capital Labor Monetary survey M = Money supply R = Reserves (NFA) D = Domestic credit (NDA) M =R+D DG = Domestic credit to government D = DG + DP DP = Domestic credit to private sector Fiscal policy determines government’s demand for bank financing (DG), which, in turn, affects total domestic credit (D), i.e., net domestic assets (ignoring other items net), and money (M) Increased budget financing requires greater monetary expansion unless credit to private sector (DP) is cut or foreign reserves (R) go down, reflecting a weaker balance of payments position In times of financial and economic crisis, fiscal policy plays key role in government’s response Fiscal policy played a role during Great Depression, even if theory behind it was poorly understood, or even disputed Fiscal policy plays key role in current crisis Monetary policy is ineffective if real interest rates cannot be reduced without igniting inflation Fiscal policy is more effective Massive fiscal stimulus in US, Europe, and Asia: it works! Fiscal stimulus is assisted by automatic stabilizers Need for financing tends to lift interest rates, so capital flows in and currency tends to appreciate Central Bank must offset incipient appreciation by expanding money supply, thereby reinforcing initial fiscal stimulus Otherwise, exchange rate could not remain fixed r Fiscal stim ulus works unde tes f ixed exchange ra Need for financing tends to lift interest rates, so capital flows in and currency appreciates Appreciation reduces net exports, aggregate demand, and interest rates Process continues until interest rates fall to their initial level But concerte d s fiscal stimulu So, fiscal stimulus is ineffective can work even with perfect capital mobility under floatin g es exchange rat times of large deficits and growing In public debt, public spending can have debt weak or even negative effects By creating expectations of a fiscal crisis, crisis and hence of higher future taxes Increased saving may lead to a sharp fall in consumption Hence, fiscal stimulus can fail, and may even prove counterproductive Conversely, fiscal contraction may prove expansionary alence v Ric ardian equi Fiscal policy is frequently key to addressing balance of payments problems Simple mechanism M = R + D means D R = D M – D D = D M – D DG – D DP Hence, given DM and DDP, key to raising DR is reducing DDG IMF: It’s Mostly Fiscal! Or look at it this way: Y = C + I + G + X – Z means X–Z=Y–C–T–I–G+T=S–I+T-G Hence, current account balance (X – Z) Z equals sum of private sector surplus of saving over investment (S – I) and I government surplus of taxes over public expenditure (T – G)G Equivalently, Z – X = I – S + G – T means that external deficit equals sum of private sector deficit and government budget deficit Unsustainable fiscal policy can trigger a crisis if public loses confidence in government’s macroeconomic policy Sudden capital outflow can result, weakening the balance of payments and leading to a sharp devaluation Financing the budget externally builds up external debt, increasing risk of crisis Fiscal sustainability thus matters not only for debt, but also for balance of payments Fiscal contraction (spending cuts, tax increases) can slow down inflation, reduce current account deficit Fiscal expansion (tax cuts, spending increases) can shrink unemployment, increase aggregate demand and help restore output to full capacity, i.e., bring actual GDP up to potential GDP, especially if monetary policy is impotent Automatic, or built-in, stabilizers are revenue or expenditure provisions that have counter-cyclical impact without need for policy intervention Protect against shocks Dampen business cycles Examples Progressive taxes on income, profits Price stabilization funds Unemployment insurance Monetary policy has been used heavily Its further impact may be limited In many countries, policy interest rates already approach zero Monetary policy may have limited effect during “balance sheet recessions,” when many firms are technically bankrupt, will use increased earnings to restore capital, and may not respond to lower interest rates Koo (2009), Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession Mixed evidence on efficacy of fiscal policy in developing countries While automatic stabilizing impulses are weak and make the case for discretion, there is also the widely noted occurrence of pro-cyclicality That is, government spending tends to rise during booms and to fall during recessions The focus of stimulus packages differs between advanced and developing countries Infrastructure spending 46% of fiscal stimulus in developing economies, but 15% in advanced economies Tax cuts over 34% of fiscal stimulus in advanced economies, only 3% in developing economies Khatiwada, S. (2009), “Stimulus Packages to Counter Global Economic Crisis; A Review,” International Institute for Labour Studies Discussion Paper 196. gain liers a Multip No clear consensus among economists about the size of fiscal multipliers (response of real GDP to tax cuts or higher spending) Recent IMF Staff Position Note reports: q A rule of thumb is a multiplier (using the definition ΔY/ΔG and assuming a constant interest rate) of 1.5 to 1 for spending multipliers in large countries, 1 to 0.5 for medium sized countries, and 0.5 or less for small open countries. q Smaller multipliers (about half of the above values) are likely for revenue and transfers while slightly larger multipliers might be expected from investment spending. q Negative multipliers are possible, especially if the fiscal stimulus weakens (or is perceived to weaken) fiscal sustainability. Source: Spilimbergo, Symansky, and Schindler (2009), “Fiscal Multipliers,” IMF Staff Position Note spn/09/11. USD billion % of GDP Tax cut share (%) Brazil 9 0.5 100 Canada 44 2.8 45 China 204 4.8 0 France 20 0.7 6 Germany 130 3.4 68 Japan 104 2.2 30 India 6 0.5 0 Korea 26 2.7 17 Russia 30 1.7 100 Spain 75 4.5 37 UK 41 1.5 73 US 841 5.9 35 Source: Eswar Prasad and Isaac Sorkin (Brookings Institution, 2009) http://www.brookings.edu/~/media/Files/rc/articles/2009/03_g20_stimulus_prasad/03_g20_stimulus_prasad_table.pdf q Solvency § Having enough assets to cover liabilities, and ability to service debts in long run q Liquidity § Ability to meet maturing obligations q Sustainability § Solvency + liquidity + no expectation of unrealistically large adjustment q Vulnerability § Risk of insolvency or illiquidity Change in Canada’s per capita GDP from year to year 1871-2003 (%) ext door? How about the U.S. n bank Canada had no major pression, fa ilures during Great De s Deposit and did not establish it ntil 1967 In surance Corporation u on during Great Perhaps bank regulati abilize GDP Dep ression also helped st Change in US per capita GDP from year to year 1871-2003 (%) on during Great Perhaps bank regulati abilize GDP Dep ression also helped st Change in UK per capita GDP from year to year 1871-2003 (%) r capita t sta ndard deviation of pe Not quite as clear, bu % 1947-2003 growth fell from 3.1% 1831-1945 to 1.8 on during Great Perhaps bank regulati abilize GDP Dep ression also helped st Change in French per capita GDP from year to year 1821-2003 (%) on during Great Perhaps bank regulati abilize GDP Dep ression also helped st Change in German per capita GDP from year to year 1851-2003 (%) on during Great Perhaps bank regulati abilize GDP Dep ression also helped st Change in Swedish per capita GDP from year to year 1821-2003 (%) Source: Maddison (2003). Objections to fiscal activism Borrowing to finance increased government expenditures raises interest rates, thereby crowding out investment and reducing multiplier At full employment, increased public spending, however financed, leads to inflation without stimulating output except temporarily Increasing spending or cutting taxes to combat unemployment may impart inflation bias to economic system Rules vs. discretion Long lags, including approval and implementation Fiscal activism may tend to expand public sector Fiscal stimulus packages need to include an exit strategy to ensure that solvency is not at risk, and should Not have permanent effects on budget deficits Provide a commitment to fiscal correction, once economic conditions improve Include structural reforms to enhance growth Should firmly commit to clear strategies for health care and pension reforms in countries facing demographic pressures Government has vital role to play in modern mixed economies (allocation role) Education Health care, cf. current debate in United States Infrastructure (roads, bridges, airports, etc.) Some would also stress government’s distribution role … … claiming that the government should try to secure reasonable equality in the distribution of income and wealth, including poverty alleviation Normative or positive economics? Partly positive: Equality is good for growth Two views r = -0.27 Inequality sharpens incentives and thus helps growth Inequality endangers social cohesion and hurts growth 117 countries, 1960-2000 Equality is good for growth r = -0.27 No visible sign here that equality stands in the way of economic growth An increase in Gini index by 16 points goes along with a decrease in per capita growth by one percentage point per year Why not raise government expenditure on public services or whatever and reduce taxes? – to buy votes Supposing all objections could be swept aside Because this would create a deficit and deficits can lead to inflation, and inflation is inflation undesirable for many reasons – it reduces efficiency and growth, for one thing Even so, a modest deficit can be sustained in a growing economy So how modest is modest? Debtaccumulation is, by its nature, a dynamic phenomenon A large stock of debt involves high interest payments which, in turn, add to the deficit, which calls for further borrowing, and so on o Debt accumulation can develop into a vicious circle How do we know whether a given debt strategy will spin out of control or not? o To answer this, we need a little arithmetic Revenues Expenditures Budget Deficit Financing Increase in debt Higher interest payments Recall operational budget deficit: G – T = DB + DDG + DDF = DD = GN + rD - T where D is total government credit outstanding Further, assume for simplicity T = GN Then, we have DD = rD This gives So, now we have: Now subtract growth rate of output from both sides: But what is ? This is proportional change in debt ratio: This is an application of a simple rule of arithmetic: %D(x/y) = %Dx - %Dy z = x/y log(z) = log(x) – log(y) Dlog(z) = Dlog(x) - Dlog(y) But what is Dlog(z) ? So, we obtain Q.E.D. s We have shown that Defic its can be sustained a s not long as debt ratio doe ., at Debt s pin out of control – i.e ratio least as long as g > r r>g where r=g r<g Time We have shown that Need economic growth to keep debt Debt ratio under control ratio r>g where r=g r<g Time We have shown that Higher interest rates can turn a sustainable Debt debt position into an ratio unsustainable one r>g where r=g r<g Time Primary deficit = GN – T = G – T – iDG Primary balance: PB = T – G + iDG Take another look Intertemporal budget constraint: Dividing by nominal GDP (= PY), we get If r > g, d rises over time nged If r = g, d remains uncha es If r < g, d declin y We have seen that Reducing primar d eficit is key to red ucing debt ratio To find where debt ratio is headed, i.e., the long-run equilibrium value of d, we set dt = dt-1; this gives y pb < 0 m eans that primar it budget b alance is in defic > 0 if pb < 0 and g > r To improve primary balance Raise and reform revenue ü Raise taxes and fees ü Reform revenue collection by levying efficient taxes and fees ü E.g., pollution fees rather than income taxes ü Improve tax administration Reduce and reform expenditure ü Emphasize efficiency ü Avoid waste Adequacy Taxes must be consistent with budgetary needs and with revenue generating capacity Simplicity Tax rules must be easy to understand and entail low administrative and compliance costs Fairness Tax system must ensure that equals pay the same and rich pay more than poor Efficiency Tax policy must minimize distortions and disincentives Broad base improves efficiency Limit holidays, exemptions, deductions, etc. Simple rates ease administration Use single or few preferably ad valorem rates Excessively high rates are ineffective Use moderate internationally comparable rates Pay attention to economic tax incidence Consider long-term consequences Revenue from broad-based sales tax Specifically, value added tax (VAT) Little reliance on trade taxes Simple personal income tax Corporate tax at single, low rate An elastic tax system VAT Single rate of 10-20% Few exemptions Trade taxes Low uniform tax on imports For protection, not revenue Avoid taxes on exports Income taxes No more than three brackets, Top marginal rate of no more than 40% Limited exemptions Corporate tax Single proportional rate of 30-40% Equalize top marginal rate of personal and corporate income taxes Prevents tax avoidance through choice of corporate or non-corporate form Few exemptions Elastic tax system Ensures that tax revenues will increase as economy grows Early 1990's Early 2000's Americas 13 16 Sub-Saharan Africa 2 9 Central Europe and the BRO 1 14 Africa and the Middle East 3 5 Asia and the Pacific 4 11 Small Islands 0 2 Total number of developing countries with a VAT 23 57 Source: Keen and Simone, 2004. 63 1990-91 2000-01 Americas 4.9 2.2 Sub-Saharan Africa 9.0 8.1 Central Europe and BRO 4.7 1.5 North Africa and Middle East 5.9 5.7 Asia and Pacific 6.3 2.7 Small Islands 10.1 8.4 Developing countries 6.5 4.2 High-income countries 3.1 1.2 Source: Keen and Simone, 2004. 64 Source: Keen and Simone, 2004. Source: Keen and Simone, 2004. Essentials of Tax Administration Reform Explicit and sustained political commitment Team of capable officials Well-defined and appropriate strategy Relevant training for staff Adequate resources for tax administration Changesin incentives for taxpayers and tax administrators United States Replace current income tax code by uniform flat tax or by national sales tax Europe Lower domestic tax rates to stimulate moribund economies Latin America and Asia Lower tariffs to improve competitiveness at home Compensate for market failure Externalities (education, health care) Public goods (national defense, air) Collective goods (fish) Social insurance Support private sector development Education Health care Infrastructure Affordability Level of public expenditure must be consistent with revenue and financing constraints Efficiency Appropriate mix of goods and services at lowest possible cost Priorities Expenditure priorities must be defined in accordance with economic goals Are expenditures productive? Equity In line with distributional objectives and poverty alleviation goals Public wages and employment Provide adequate operations and maintenance spending Eliminate subsidies and target transfers Minimize military expenditure Encourage capital expenditures Eliminate unproductive spending General Average Ratio of government central public to employment as government private percent of total wage to per sector nonagricultural capita GDP wages employment Asia 3.0 0.8 56.7 Eastern Europe and Central Asia 1.3 0.7 54.6 Latin America and Caribbean 2.5 0.9 20.9 Middle East and North Africa 3.4 1.3 53.7 Sub-Saharan Africa 5.7 1.0 37.8 OECD 1/ 1.6 0.9 23.0 Sources: World Bank, ILO, and OECD. Data refer to 1996 - 2000 average. 72 Identify white elephants Look for proximate indicators of misallocation Literacy rates Mortality rates Identify sectoral expenditure imbalances E.g., high teacher/pupil ratio with inadequate teaching supplies Identify allocative inefficiency E.g., generalized subsidies Avoid across-the-board cuts Be selective Target needed cuts Consider capacity for efficient project realization Focus on medium-term rather than one-shot measures Emphasize sound incentives, targeting, and transparency Address budget rigidity Address fiscal federalism Use fiscal policy to promote economic growth Long-rungrowth is endogenous, and responds to fiscal and monetary policy Monetary policy? Yes, because low inflation is good for economic growth Many countries face budgetary problems from mandatory expenditures Creating automatic outlays, without needing formal approval by the government Examples Loan guarantees Public pensions, health insurance, jobless benefits Deposit insurance programs Tax expenditures Automatic reductions in tax liability for those with qualifying expenses Challenge is to reduce pre-committed spending Some options are Limit tax expenditures Put ceilings or require minima on amount of expenses qualifying for deductibility from taxable income Reform public pension programs Consider shifting to basic minimum benefit plus mandatory saving (defined contribution plan) U. K. (minimum benefit), Chile (more extensive reforms) Limit loan guarantees and deposit insurance Insurance should not provide 100% coverage Many countries allocate expenditure responsibilities to multiple levels of government Advantages May be more responsive to local needs Possibly better management Subsidiarity principle Disadvantage May be harder to control fiscal performance as a whole Challenge is to ensure adequate funding for services at all levels while achieving overall fiscal objectives Different countries have different ways of maintaining discipline Balanced budget rules (common in US) Restrictions on borrowing by state and local governments (common in Brazil, India) Look for enforceability of restrictions and ability of sub- federal units to evade limits Tax policy Consistent with investment-friendly business climate and adequate funding for government Expenditure policy Supply productive “public goods” Address externalities efficiently Restrict monopolies, promote competition Foster good governance, rule of law Provide financial regulation and safety nets Support private sector activity while focusing on those things that government can do better than private sector Avoid inflation, inefficiency, excessive inequality Creating an investment-friendly tax climate Moderate overall tax burden that allows financing efficient levels of government activity Focus taxes on consumption rather than income, to reduce double taxation of savings Modest income tax Limiting payroll tax burden Keeping corporate profit taxes modest Address double taxation of dividends Keep tax burden competitive with neighboring and comparable jurisdictions; may require moderating corporate profit tax rate Be serious about stabilization, allocation, and distribution Keep spending consistent with revenue levels, to avoid heavy debt and debt service levels Build and maintain productive infrastructure Maintain effective education system Maintain cost-effective health care system Maintain impartial and effective courts Maintain appropriate regulatory environment, especially for financial sector and other sectors with important economy-wide externalities Also, encourage private sector Sound fiscal policy is critical for good macroeconomic management, and can help manage capital flows Fiscal stimulus is usually expansionary, but not invariably Fiscal policy crucially affects BOP, and interacts with monetary policy Fiscal policy, as before, is crucial to responding to financial crises Especially when monetary policy lands in liquidity trap and loses traction Fiscal policy can help foster rapid growth
"Macroeconomic management and fiscal policy"