Long-Term Fiscal Sustainability: Recent Advances and Future Challenges

Opening Address by Murilo Portugal
Deputy Managing Director, IMF
At the IMF Offices in Europe/Fiscal Affairs Department Seminar
Paris, July 5, 2007

Ladies and gentlemen:

It is a pleasure to be here today, and to deliver the opening address at this seminar on long-term fiscal sustainability. As Mrs. Ter-Minassian has said, our discussions take place against the backdrop of substantial improvement in public finances in many countries of Europe and elsewhere. These improvements are due in roughly equal measure to structural and cyclical factors. Countries have taken difficult steps to strengthen their underlying fiscal positions, while stronger economic activity has boosted tax revenues and reduced spending on unemployment benefits.

Despite this improvement, long-term fiscal sustainability has yet to be secured in many countries. Moreover, it will remain elusive if an expectation of continued benign economic conditions leads to complacency. Indeed, there are already signs that adjustment fatigue may be setting in: present budgetary plans offer little adjustment through 2008, especially in some larger European countries. Given the challenges posed by population aging, globalization, climate change, and the heightened risks they and some other fiscal developments entail, it will be impossible to ensure fiscal sustainability without strong policy action. The current good times provide an opportunity to direct the focus of fiscal policy to the challenges that lie ahead.

I should say at the outset that global nature of these challenges makes them amenable to a cooperative policy response. This being the case, national governments should work together to seek mutually agreeable solutions. In this connection, the IMF and other international institutions can contribute by bringing a cross-country perspective to the issues. In this connection, I would like to highlight the IMF's Medium-Term Strategy, which emphasizes the need for the IMF to undertake deeper analysis in the context of multilateral surveillance.

But let me return to the main policy challenges and give a brief perspective on some of the key sustainability issues.

Population Aging

There is little doubt that the most important of these issues relates to the ongoing and projected shifts in the demographics of European countries, and elsewhere. In the coming decades, rising longevity, falling fertility rates, and the retirement of the baby boom generation will markedly raise age-related government spending in most advanced and many emerging market countries. By 2050 the population in most advanced countries is expected to be smaller and considerably older, with old-age dependency ratios projected to double. This is quite an extraordinary development which will have wide- ranging implications for virtually every aspect of society and the economy. Specifically in the fiscal domain, the upward pressure on age-related expenditures by the public sector—due for example to additional spending on pensions, health, and long-term care—is likely to be significant: the European Commission's and our estimates suggest that for the EU25 as a whole, the average increase is likely to be in the region of 3½ to 4 percent of GDP. Such pressures are not limited to Europe: in the case of the United States, the increase in age-related spending over 2005-50 is projected at almost 6 percent of GDP, and there are marked aging related budgetary pressures in Japan.

Moreover, as the aging pressures increase, inadequate public and private pension provision is likely to create additional demand for government spending. This is already apparent in the United Kingdom, where the pensions commission recently recommended the introduction of new welfare schemes to combat rising old-age poverty. Private pension schemes could also turn out to be less secure than anticipated. Private pension guarantee payments are already rising in the United States as struggling companies unload their pension obligations on to the government. And in countries such as Chile, which privatised their social security schemes by moving to a defined contribution system, there are pressures to reinstate a universal pension.

Given these trends, it is not surprising that there is now a broad agreement that public debt burdens would be unsustainable under current policies in Europe, as well as in the United States and Japan. This assessment applies even in the case of the low estimates regarding the increased cost of pensions and health care. The estimated fiscal adjustment required to ensure long-run fiscal sustainability is substantial for all of the most advanced economies, typically ranging between 3-4 percentage points of GDP. This adjustment need reflects the expected increase both in age-related spending, as well as the interest on current public debt. Although recent pension reforms in many countries are a welcome step in the right direction, they have not yet been sufficient to make public finances sustainable.

As the need for adjustment and its approximate size are by now well-established facts, attention is rightly shifting to the specifics of the nature of adjustment and its impact. There are three areas that are particularly worth noting in this regard: first, the timing of the adjustment to long-term challenges; second, and an area that has received insufficient attention, the potential role of a cooperative strategy to deal with the global consequences of adjustment to aging in most large economies; and third, the interaction with structural reforms—in the case of EU, the Lisbon Agenda.

With regard to the first area, I should mention the increasing evidence on the benefits of early action and the substantial medium-term growth dividend that would arise from putting public finances on a sustainable footing in the near term. With regard to the second, a particularly important issue relates to the extent to which the near-term contractionary effects of fiscal consolidation in a wide range of countries can be moderated if there is international cooperation. Such cooperation could for instance lead to a decline in global longer-term interest rates, providing offsetting stimulus to activity. Complementary structural reforms undertaken by a number of countries simultaneously could also have beneficial effects for growth. These issues are analyzed in today's first presentation.

Climate Change

As you all know, the reports of the Stern Commission and the Inter-governmental Panel on Climate Change paint a worrying picture of likely adverse effects of climate change on the economic performance and the public finances of many countries worldwide. The possible economic impact of climate change arises from a variety of sources: for instance, there are likely to be substantial output losses and increased fiscal outlays due to more frequent and destructive weather events, and sea level rise. In addition, there could be considerable fiscal pressures from costs of adaptation to climate change and mitigation of greenhouse gases. Last but not least, there are likely to be balance of payments difficulties due to adverse changes in exports and imports.

The Stern report estimates the annualized cost of necessary green house gas abatement as 1 percent of global GDP. It sketches an alternative emissions path involving substantial emissions abatement, based largely on the development of alternative energy sources, involving global emissions falling 25 percent by 2050. Otherwise, global output losses due to climate change are estimated at an annualized 5 percent of GDP, and possibly as much as 20 percent.

I should emphasize that the Intergovernmental Panel on Climate Change broadly confirms the Stern report. However, reflecting the large uncertainties surrounding estimates of the costs of reducing emissions that contribute to global warming, the use of a different discount rate, and less ambitious emission reduction targets, the Panel concludes that the costs of emission-reducing policies could be rather lower. Both recommendations use a range of tax policy instruments to reduce carbon emissions.

The Fund's Fiscal Affairs Department has begun to undertake work on the challenges raised by climate change, both their impact on IMF member countries, and the related policy challenges. The presentation we will hear today examines what is at stake, and the costs of delaying action.

Globalization and Government Finances

Another important aspect of fiscal sustainability relates to the impact of globalization on government revenues and expenditures. There is no doubt that the ability of factors to migrate to areas where they can increase returns has considerable benefits in enhancing efficiency and economic potential of countries worldwide. But there is equally little doubt that globalization is likely to have a substantial effect on countries' ability to sustain tax revenues, given the difficulties in maintaining high tax rates on mobile factors of production.

Evidence of the impact of heightened tax competition for capital has been mounting. In the OECD countries, and the EU specifically, statutory corporate tax rates have declined sharply over the past decade. But so far there has not been a pronounced fall in government revenues in many countries, despite the reduction in tax rates. We are not quite sure why this is so: It could reflect in part the fact that the tax base has increased, due to the beneficial effects of globalization on productivity and growth. It could also reflect an expansion in the types of activities covered by taxes, and efforts to broaden the tax base by removing exemptions could have also been bearing fruit. In addition, the cyclical surge in corporate tax revenues has played a role. However, it is far from clear to us and to many others that there would not be more marked adverse effects on revenues in the future. Were that to happen, the implications for sustainability given the other challenges I have noted will become even more serious.

The story does not end here. At the same time, there is increasing evidence that globalization is likely to increase demand for government spending, particularly on transfer payments in the wake of restructuring due to intensified competition. Although there is so far little evidence that globalization per se—rather than technological change—is responsible for the growing income inequality in most advanced economies, policy makers will find it difficult to resist public pressure to compensate the parts of the population that are adversely affected by the further opening of economies. Moreover, globalization is also likely to increase financial risks, with substantial fiscal implications. A rise in risk aversion could entail large corrections in asset classes that have seen rapidly rising valuations, with systemic implications. These financial risks can translate into fiscal risks, in part as they have an impact on government contingent liabilities.

Exploring further future trends in taxation, the presentation today look at the future of corporate tax world-wide; the links between corporate and other taxes; and tax policy coordination.

Fiscal Risks and Contingencies

The last aspect of fiscal sustainability I want to highlight concerns fiscal risks and contingencies. Fiscal risks are pervasive, they are a threat to sustainability, and yet they are often ignored. Contingent liabilities arising from guarantees and other stand-behind obligations are a potent source of hidden deficits and debt that have proved to have significant fiscal implications, especially during financial crises.

Key questions that arise relate to the different sources of fiscal risk, in particular the contingent liabilities associated with public-private partnerships. These are becoming commonplace in Europe, but accounting and reporting standards that are applied to them encourage their misuse by allowing their true costs and risks to be hidden. The case for disclosure of all sources of fiscal risk, and for their quantification is now well established. Moreover, the various approaches to reflecting contingent liabilities in debt sustainability analysis, and to managing fiscal risk, both in connection with public-private partnerships and more generally need to be examined closely. This is done in the last presentation today.

Public opinion

There is no doubt that public finances in the advanced economies will face an exceptional confluence of challenges during the upcoming years. Expenditure pressures on various fronts are likely to coincide with adverse dynamics in revenues as the ability to tax mobile factors of production weakens, while economic growth is likely to slow as labor forces decline in size and productivity growth may level off. This provides a radically different environment for fiscal policy than in past decades that were characterized by benign demographics, rapid productivity growth, relatively low commodity prices, and the uninhibited exploitation of natural resources more generally.

Preparing public opinion for this new environment will be crucial for the success of policies to put public finances on a sustainable long-term footing. Past experience, for example in the context of the fiscal adjustment that many countries implemented to qualify for Euro accession, shows that the public opinion will be considerably less hostile to fiscal reforms when their motivation and benefits are sufficiently well communicated.

In this context, institutions that are seen as providing analysis that is independent from the national party politics and interest groups can play a very useful role and ultimately help policy makers to adopt unpopular yet necessary reforms. On the international level, the European Commission, the OECD, and the IMF play such a role. However, many countries have such independent institutions also on the national level.

Cooperative Solution

As I noted at the outset, a shared feature of all four key challenges to fiscal sustainability—aging, climate change, globalization, and fiscal risks—is that they transcend the boundaries of national policymaking. The fact that large parts of the world economy will face the economic and fiscal consequences at the same time implies the danger of beggar-thy-neighbor policies, or, alternatively, scope for gains from cooperation, as we will discuss in more detail later. Similarly, many of the largest fiscal risks many countries face today are of a transnational nature, particularly those stemming from the financial markets. Finally, for climate change and the pressures from globalization on public finances—particularly tax competition—it goes without saying that policies will have to be internationally coordinated to be effective.

The gatherings such as the one we have here can help strengthen the mutual understanding of countries' perspectives on policy challenges and contribute to better cooperation. In this spirit, I look forward to the interesting presentations and a lively debate.



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