IMF's Independent Evaluation Office (IEO) Releases Report on The Role of Fiscal Adjustment in IMF-Supported Programs

The IEO today released its third evaluation report which deals with fiscal adjustment in IMF-supported programs. The report uses cross section analysis of 133 programs supplemented by a more detailed examination of 15 programs. The Executive Board discussions took place on August 29, and the full text of the report and the Summing Up of the discussions can be found at http://www.imf.org/external/np/ieo/2003/fis/index.htm.

Major findings

1. The evidence does not suggest a "one-size-fits-all" approach with austerity and inflexibility in fiscal targets.

• There is considerable variation in the scale of fiscal adjustment programmed across countries and not all programs are characterized by austerity. In fact, 40 percent of programs examined targeted a widening of the current account deficit as a percent of GDP while about 1/3 programmed an increase in the primary fiscal deficit and primary spending as a percent of GDP.

• Program targets are often revised during program implementation, suggesting that there is flexibility in practice.

2. There is no evidence of a generalized decline in growth in program years but there may be a contractionary bias in the fiscal design in certain circumstances.

• The cross-country evidence does not show that growth rates decline systematically in program years. However, there is considerable inter-country variation in behavior and in a number of cases, particularly in some of the capital account crisis cases, growth did slow down and sometimes became negative.

• Many programs are overoptimistic in projecting growth especially when programs start from adverse situations. In particular they are reluctant to project a slowdown in growth and very rarely project negative growth. This has potentially significant implications for program design because it means that the need for countercyclical fiscal policy is rarely discussed explicitly.

• The possibility of a contractionary bias in fiscal adjustment arises because programs tend to be overoptimistic in projecting the recovery of private investment and economic growth, thereby targeting stronger fiscal adjustment than necessary. In a number of cases there is more external adjustment and larger reserve accumulation than programmed, suggesting that higher current account deficits could have been sustained from the financing side. In these circumstances, one could argue that a looser fiscal policy would have played a useful countercyclical role.

• The report recognizes that the fiscal stance cannot be determined solely on countercyclical grounds. Where debt sustainability is an issue, a loose fiscal stance justified on countercyclical grounds may actually prove to be destabilizing if it is misread by markets as indicating a lack of commitment to macro stability, leading to a delayed return of confidence. Weighing these different considerations is complex, but these issues need to be explicitly discussed and explained in program documentation, which is generally not done (see below).

3. A major weakness is that program documents often do not clearly explain the rationale for the magnitude and pace of the fiscal adjustment.

• The report indicates that the scale of adjustment needed in individual cases should be determined by a number of factors including aggregate demand side considerations, debt sustainability, and signaling effects on markets. However, it finds that program documents do not explain the rationale of fiscal adjustment in terms of these considerations. It is not clear how the proposed adjustment fits into the other assumptions underlying the program, especially the revival of private investment. This weakness reduces the transparency of the program. It prevents identifying the critical assumptions that need to be monitored as the program unfolds so as to identify midcourse corrections.

4. The internal review process does not contribute as much as it could at the initial stage of program design.

• An examination of the internal review process revealed that the scope and detail of comments of the review departments was greater at the stage of program implementation than at the stage of initial program design. The process tends to be reactive—with reviewers commenting increasingly as the programs unfold instead of at the design stage when comments could be most useful in exploring alternatives.

5. Fiscal consolidation does not seem to extend beyond the first year, and sustained progress with fiscal reforms that improve resilience is often not satisfactory. Article IV consultations do not forcefully flag policy inaction—often they are not candid enough.

• Many of the fiscal measures in programs aimed at quickly reducing fiscal deficits exhaust themselves over time or become reversed. Raising value added or social security taxes when the tax base is narrow increases tax evasion. Measures to cap public sector wages are difficult to sustain beyond the program period.

• What is needed are institutional reforms to reduce tax evasion, curtail exemptions, widen the tax base, and promote civil service reform. They are critical to improving the underlying fiscal situation and require sustained efforts and determination on the part of the authorities. The evaluation finds that progress in this area has been generally disappointing.

• Surveillance could be used as a vehicle to monitor and encourage progress in developing a long-term fiscal reform agenda owned by the authorities, but the evaluation finds that this has often not been the case. Surveillance is drawing too few lessons from past failures, often not setting a road map for future more complex reforms.

6. There is no evidence that IMF-supported programs, in and of themselves, have an adverse effect on aggregate social spending but maintenance of aggregate spending may not be sufficient to protect the most vulnerable groups under crisis situations.

• The evaluation uses an econometric analysis of 146 countries from 1985 to 2000, looking at years with and without an IMF-supported program to address this issue. The results show that the presence of an IMF-supported program in and of itself does not reduce public spending in either health or education—measured as a share of total public spending, GDP, or in per capita real terms. In fact, we estimate that during program periods, and with all other factors being the same, public spending in each of the health and education sectors may slightly increase temporarily compared to a situation without a program. This increase is sustained beyond the end of the program but it diminishes over time.

• However, the fact that aggregate social spending is not reduced does not establish that the most vulnerable groups are effectively protected from economic shocks during program years. An important finding from the case studies is that programs and spending categories that are most critical to vulnerable groups are often squeezed out by other expenditures in the same broad category (basic medical or primary school supplies are usually preempted by personnel expenditures in periods of budgetary stress).

• Unless governments already have in place budgetary mechanisms that allow for the protection of these critical programs in real time during crisis situations, IMF-supported programs generally have too short a time frame and the IMF lacks the necessary expertise to assist in implementing such policies. A framework is required to encourage countries to put in place these programs beforehand.

7. The Evaluation has put forward the following recommendations:

1. Program documentation should provide a clear justification for the magnitude and pace of the targeted fiscal adjustment and how it is linked with assumptions about the recovery of private sector activity and growth.

2. The internal review mechanism should place relatively more emphasis on the early stages of the process. A more intensive process of brainstorming is needed at the time of the initial brief, and that brief should also articulate more clearly the basis for the fiscal program, including debt sustainability issues.

3. Programs should give greater emphasis to the formulation and implementation of key structural reforms in the fiscal area, even if (as is likely) they cannot be fully implemented during the program period.

4. Surveillance should be used more explicitly to provide a longer term road map for fiscal reforms and to assess progress achieved (in non-PRGF countries). It will allow the authorities flexibility in the timing and packaging of reforms which is often lost if these reforms are flagged at the last minute in the context of a crisis situation.

5. The IMF should assist middle-income countries in preparing budgetary mechanisms to protect the most vulnerable in case of external shocks and budgetary retrenchments. Specifically, the IMF could invite the authorities during Article IV consultations to suggest what are the critical social programs and services they would like to see protected in such situations. Once identified, the World Bank and the IMF could agree with the authorities on an accelerated program of public expenditure management systems specifically geared to protect these programs.

IEO Contact: Marcelo Selowsky
MSelowsky@imf.org
(202) 623-4156