FISCAL POLICY

Thorvaldur Gylfason
IMF Institute/Center for Excellence in Finance, Slovenia
Course on Macroeconomic Management and Financial Sector Issues
Ljubljana, Slovenia
September 21–29, 2011
OUTLINE
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
DEFINITION OF FISCAL POLICY
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
OBJECTIVES OF FISCAL POLICY 1
1. Stabilization
 Fiscal policy influences aggregate demand
 Directly because Y = C + I + G + X – Z
 Indirectly because C depends on income after tax
 Throughdemand, 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
OBJECTIVES OF FISCAL POLICY
 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
STABILIZATION POLICY
Demand management
E.g., lower income taxes

Aggregate supply
in short run
Price level

A
Aggregate
demand

Output
STABILIZATION POLICY
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

A
Aggregate Aggregate
B
demand demand

Output Output
 Y = GDP
C = Consumption
I = Investment
BASIC RELATIONSHIPS 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
 S = Y – T – C = I + G – T + X – Z, so DGG = Credit from banking system
DFF = 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 onary
Inflattiio ry vs.
in fla
a ti
tioon ary fi
finnance
 G – T = B + DG + DF n on fl
 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
FISCAL POLICY AND INFLATION
 Central bank financing involves money creation
 Inflation tax: Most inflationary form of financing
 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
FISCAL POSITION:
ALTERNATIVE CONCEPTS
 Conventional budget surplus
at
T –G Pro
Pr blem here is not th
ob
rge but
ut
deficit is too la
de
 Large in upswings when tax base (Y) is strong that inco
com me is too low
n
 Small in downswings when tax base is weak Economic expansio
would automatica cally
rp s,
 Full-employment surplus turn deficciitt into su lu
en
T, G om red to green
from
 TFE – 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
FISCAL POSITION:
ALTERNATIVE CONCEPTS
 Public sector borrowing requirement
 Broadmeasure 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

GNN = Noninterest expenditure

GII = Interest expenditure
i = Nominal interest rate
DGG = Government debt outstanding
FISCAL POSITION:
ALTERNATIVE CONCEPTS
 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: GNN = Noninterest expenditure
 G – T = GN + iDG – T = GN + (r + p)DG – T G = Interest expenditure
II

r = Real interest rate

 Operational deficit: DGG = Government debt
 G – T - pDG = GN – T + rDG p = Inflation rate

 Hence, operational deficit includes only real part of

interest payments, leaves out the inflation part
USES OF FISCAL POLICY
 Before Great Depression 1929-39, many
thought that governments needed to
balance their budgets from year to year
 Evenso, 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

USES OF FISCAL POLICY
 Multiplier analysis
 Itcould 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
USES OF FISCAL POLICY
 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

 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
USES OF FISCAL POLICY
 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
re tur n to this
Will
FISCAL POLICY TRANSMISSION

(-) RE
Gov’t Budget (+) (-)
Consumption
Balance (+)
(+) (-) (+)
Tax (+) (+)
revenue Expenditure Income Interest Rate

(+) (-)
(-) Investment
Fiscal Policy
(+)
(+) Capital
Labor
FISCAL AND MONETARY
POLICY
 Monetary survey M = Money supply
R = Reserves (NFA)
M D = Domestic credit (NDA)
=R+D DGG = Domestic credit to government
 D = DG + DP DPP = 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
FISCAL AND MONETARY
POLICY
 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
FISCAL STIMULUS WITH FIXED
EXCHANGE RATE REGIME
 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 Fisca l s ti
timm u lu s w ork s u nder
fixed exchange rates
FISCAL STIMULUS WITH FLOATING
EXCHANGE RATE REGIME
 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 concerted
ffiiscal stimulus
 So, fiscal stimulus is ineffective can work even
with perfect capital mobility under floating
s
exchange rate
FISCAL STIMULUS IN CRISES OF
CONFIDENCE

 In times of large deficits and growing

public debt, public spending can
have weak or even negative effects
By creating expectations of a fiscal 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
i an e qui va le nce
expansionary Ricard
FISCAL POLICY AND BALANCE
OF PAYMENTS
 Fiscal policy is frequently key to
addressing balance of payments
problems
 Simple mechanism
M = R + D means
DR = DM – DD = DM – DDG – DDP
Hence, given DM and DDP, key to raising
DR is reducing DDG
IMF: It’s Mostly Fiscal!
FISCAL POLICY AND BALANCE
OF PAYMENTS
 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)
equals sum of private sector surplus of
saving over investment (S – I) and
government surplus of taxes over public
expenditure (T – G)
Equivalently, Z – X = I – S + G – T means that
external deficit equals sum of private sector
deficit and government budget deficit
FISCAL POLICY AND BALANCE
OF PAYMENTS
 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 POLICY IN ACTION IN
THE SHORT RUN
 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 STABILIZERS
 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
GLOBAL FINANCIAL CRISIS AND
FISCAL POLICY RESPONSE
 Monetary policy has been used heavily
2
 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
GLOBAL FINANCIAL CRISIS AND
FISCAL POLICY RESPONSE
 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
GLOBAL FINANCIAL CRISIS AND
FISCAL POLICY RESPONSE
 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.
GLOBAL FINANCIAL CRISIS AND
s aga in
FISCAL POLICY RESPONSE Multiplie r

 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:
 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.
 Smaller multipliers (about half of the above values) are likely for
revenue and transfers while slightly larger multipliers might be
expected from investment spending.
 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.
 FISCAL STIMULUS PLANS 2008
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
KEY CONCEPTS
Solvency
 Having enough assets to cover liabilities,
and ability to service debts in long run
Liquidity
 Ability to meet maturing obligations
Sustainability
 Solvency + liquidity + no expectation of
unrealistically large adjustment
Vulnerability
 Risk of insolvency or illiquidity
STABILIZATION WORKED, OR
WHAT?
Change in Canada’s per capita GDP from year to year 1871-2003 (%)
20
ab o u t th e U .S. next door?
How
15

10

0
1871 1877 1883 1889 1895 1901 1907 1913 1919 1925 1931 1937 1943 1949 1955 1961 1967 1973 1979 1985 1991 1997 2003

-5

-10
h ad n o majo orr ban
ankk
Can
anaadda ha no
re s du ri
ur n
in g G rea
att D epression,
n,
failu
ur es d
eposit
and did not establish its Dep
-15
til 1967
-20 Insurance Corporation un
 on d urriin
ng gGGrre
eaatt
Perhaps bank regulation du
STABILIZATION WORKED, OR pr es si
Depressio on
n al
a so
lso hel pe d stab il
ili e GD
izze GDP P

WHAT?
Change in US per capita GDP from year to year 1871-2003 (%)
20

15

10

0
1871 1877 1883 1889 1895 1901 1907 1913 1919 1925 1931 1937 1943 1949 1955 1961 1967 1973 1979 1985 1991 1997 2003

-5

-10

-15

-20

-25
 on d urriin
ng gGGrre
eaatt
Perhaps bank regulation du
STABILIZATION WORKED, OR pr es si
Depressio on
n al
a so
lso hel pe d stab il
ili e GD
izze GDP P

WHAT?
Change in UK per capita GDP from year to year 1871-2003 (%)
15

10

0
1831183818451852185918661873188018871894190119081915192219291936194319501957196419711978198519921999

-5

-10

stan d
daar
rdd d ev ia ti on of ppeerr capita
Not quite aass clear , b ut
83 1-19 4
94 5 to 1. 8 % 19
1 47
94 7--2
20003
03
-15
fe ll fr o
omm 3 .1 % 1
18 31 -1
owth
grow
 on d urriin
ng gGGrre
eaatt
Perhaps bank regulation du
STABILIZATION WORKED, OR pr es si
Depressio on
n al
a so
lso hel pe d stab il
ili e GD
izze GDP P

WHAT?
Change in French per capita GDP from year to year 1821-2003 (%)
50

40

30

20

10

0
1821 1829 1837 1845 1853 1861 1869 1877 1885 1893 1901 1909 1917 1925 1933 1941 1949 1957 1965 1973 1981 1989 1997

-10

-20
 on d urriin
ng gGGrre
eaatt
Perhaps bank regulation du
STABILIZATION WORKED, OR pr es si
Depressio on
n al
a so
lso hel pe d stab il
ili e GD
izze GDP P

WHAT?
Change in German per capita GDP from year to year 1851-2003 (%)
20

10

0
1851 1858 1865 1872 1879 1886 1893 1900 1907 1914 1921 1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998

-10

-20

-30

-40

-50
 on d urriin
ng gGGrre
eaatt
Perhaps bank regulation du
STABILIZATION WORKED, OR pr es si
Depressio on
n al
a so
lso hel pe d stab il
ili e GD
izze GDP P

WHAT?
Change in Swedish per capita GDP from year to year 1821-2003 (%)
10

0
1821 1829 1837 1845 1853 1861 1869 1877 1885 1893 1901 1909 1917 1925 1933 1941 1949 1957 1965 1973 1981 1989 1997

-5

-10

-15
Source: Maddison (2003).
LIMITS OF FISCAL POLICY
 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
EXIT STRATEGY
 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
USES OF FISCAL POLICY
 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
INEQUALITY AND GROWTH
 Two views

Per capita growth adjusted for intial income (%)

r = -0.27
 Inequality sharpens 6

incentives and thus 4

helps growth 2

0
 Inequality -2

endangers social -4

cohesion and hurts -6

growth -8
10 20 30 40 50 60 70

 117 countries, Gini index of inequality

1960-2000
INEQUALITY AND GROWTH
 Equality is good for

Per capita growth adjusted for intial income (%)

growth r = -0.27
6
 No visible sign here that 4

equality stands in the 2

way of economic growth 0

 An increase in Gini -2

index by 16 points goes -4

along with a decrease in -6

per capita growth by -8

one percentage point 10 20 30 40 50 60 70

per year Gini index of inequality

USES OF FISCAL POLICY
 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
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?
PUBLIC DEBT DYNAMICS
 Debt accumulation 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
DEFICITS AND DEBT
Revenues Expenditures

Budget Deficit

Financing

Increase in debt

Higher interest payments

PUBLIC DEBT DYNAMICS
 Recall operational budget deficit:
G – T = B + DG + DF = D = GN + rD - T
where D is total government credit outstanding
 Further, assume for simplicity
T = GN
 Then, we have
D = rD
This gives ΔD

r
D
PUBLIC DEBT DYNAMICS
So, now we have:
ΔD
r
D
Now subtract growth rate of output from
both sides:
ΔD ΔY
  r-g
D Y Y
g
Y
PUBLIC DEBT DYNAMICS
But what is
ΔD ΔY
 ?
D Y

This is proportional change in debt ratio:

D
Δ 
ΔD ΔY Y
    This is an application of a
D Y D
simple rule of arithmetic:
Y
%(x/y) = %x - %y
PROOF
z = x/y
log(z) = log(x) – log(y)
log(z) = log(x) - log(y)
But what is log(z) ?
dlog(z) dz 1 Δz
Δlog(z)    
dt dt z z
So, we obtain Δz Δx Δy
 
z x y
Q.E.D.
DEBT, INTEREST, AND GROWTH
ficcits can be ssu ained as
ustta
We have shown that Defi
o e s no t
lo ng a s d e b t ra t io d
ro l – i. e., at
Δd Debt sp in o u t o f c o nt
 rg ratio leastst as long as g > r
d
rg
where

D r=g
d
Y
rg
Time
DEBT, INTEREST, AND GROWTH
We have shown that Need economic
o keep debt
owth tto
grro
Δd Debt ratio under contr ol
tro
 rg ratio
d
rg
where

D r=g
d
Y
rg
Time
DEBT, INTEREST, AND GROWTH
We have shown that Higher interest st rates
ust
urn a ssu
can ttu staainable
Δd Debt debt position into an
 rg ratio ust
unssu ainable one
sta
d
rg
where

D r=g
d
Y
rg
Time
 Primary deficit = GN – T = G – T – iDG
Primary balance: PB = T – G + iDG

DEBT, INTEREST, AND GROWTH

 Take another look
 Intertemporal budget constraint:
Dt  1  it  Dt-1  PBt
 Dividing by nominal GDP (= PY), we get
Dt

 1  it  Dt 1 PBt

1  rt 
1  it
1 t
PY
 t t  1   t   1  gt  Pt 1Yt 1 PY
   t t
dt dt 1 pbt

me
es over ttiim
If r > g, d rriisse
 1  rt  hanged
d t   d t-1  pbt If r = g, d remains unc
 1  gt  If r < g, d declines
DEBT, INTEREST, AND GROWTH
 We have seen that Reducing primary
 1  rt  deficit is key to
d t   d t-1  pbt
 1  gt  educing debt ratio
rre
 To find where debt ratio is headed,
i.e., the long-run equilibrium value of
d, we set dt = dt-1; this gives
(1  gt ) pbt ary
dt   pb < 0 means that prim
et balan ce is in d eficit
gt  rt bud g

> 0 if pb < 0 and g > r

FISCAL REFORM:
REDUCING DEFICITS 3
 To improve primary balance
 Raise and reform revenue
 Raise taxes and fees
 Reform revenue collection by levying
efficient taxes and fees
 E.g., pollution fees rather than income taxes
 Improve tax administration
 Reduce and reform expenditure
 Emphasize efficiency
 Avoid waste
RAISING REVENUE:
PILLARS OF TAX POLICY DESIGN
 Adequacy
 Taxesmust be consistent with budgetary needs
and with revenue generating capacity
 Simplicity
 Taxrules 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
RAISING REVENUE:
GENERAL TIPS FOR TAX DESIGN
 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
RAISING REVENUE: DESIRABLE
PROPERTIES OF TAX SYSTEM
 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
RAISING REVENUE:
GENERAL GUIDELINES
 VAT
Singlerate 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
RAISING REVENUE:
GENERAL GUIDELINES
 Corporate tax
 Singleproportional 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
RAISING REVENUE: NUMBER OF
COUNTRIES WITH VAT
  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.
RAISING REVENUE: EFFECTIVE
RATE OF TRADE TAXATION
  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.  

RAISING REVENUE: STATUTORY
RATES OF PERSONAL INCOME
TAX
45.0
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Low-income Lower-middle- Upper-middle-
countries income countries income countries

1990-91 1998-99

Source: Keen and Simone, 2004.

RAISING REVENUE: CORPORATE
TAX RATES 2000 (% OF GDP)
12.0 40.0
10.0 35.0
30.0
8.0 25.0
6.0 20.0
4.0 15.0
10.0
2.0
5.0
0.0 0.0
Americas Sub- Central North Asia and Small
Saharan Europe Africa and Pacific Islands
Africa and BRO Middle
East

Corporate Tax Revenue (LHS) Avg.Tax Base (LHS)

Avg. Statutory Rate (RHS)

Source: Keen and Simone, 2004.

RAISING REVENUE: REFORMING
TAX ADMINISTRATION
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
 Changes in incentives for taxpayers and tax
administrators
REFORMING FISCAL POLICY:
EXAMPLES
 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
REFORMING EXPENDITURE:
PILLARS OF EXPENDITURE POLICY
 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
REFORMING EXPENDITURE:
PILLARS OF EXPENDITURE POLICY
 Affordability
 Levelof 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
 Inline with distributional objectives and poverty
alleviation goals
REFORMING EXPENDITURE:
KEY ITEMS OF EXPENDITURE
 Public wages and employment
 Provide adequate operations and
maintenance spending
 Eliminate subsidies and target
transfers
 Minimize military expenditure
 Encourage capital expenditures
 Eliminate unproductive spending
 WAGES AND EMPLOYMENT
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.
REFORMING EXPENDITURE:
UNPRODUCTIVE EXPENDITURE
 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
REFORMING EXPENDITURE:
GENERAL TIPS FOR ADJUSTMENT
 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
REFORMING EXPENDITURE:
FURTHER TIPS FOR ADJUSTMENT
 Address budget rigidity
 Address fiscal federalism
 Use fiscal policy to promote
economic growth
Long-run growth is endogenous, and
responds to fiscal and monetary policy
 Monetary policy?
 Yes, because low inflation is good for

economic growth
REFORMING EXPENDITURE:
BUDGET RIGIDITY
 Many countries face budgetary problems
from mandatory expenditures
 Creatingautomatic 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
REFORMING EXPENDITURE:
BUDGET RIGIDITY
 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
REFORMING EXPENDITURE:
FISCAL FEDERALISM
 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
REFORMING EXPENDITURE:
FISCAL FEDERALISM
 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
FISCAL POLICY FOR GROWTH
IN THE LONG RUN
 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
TAX POLICY FOR GROWTH IN
THE LONG RUN
 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
EXPENDITURE POLICY FOR
GROWTH IN THE LONG RUN
 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
CONCLUSION
THE END
 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