Guidelines for Fiscal Adjustment

Why May Fiscal Adjustment Be Needed?

The need for fiscal adjustment may be seen in the context of the impact of fiscal policy on stabilization and growth objectives, the sustainability of the fiscal policy stance, and the linkages between fiscal and other policy instruments.

The Impact of Fiscal Policy on Macroeconomic Policy Objectives

In most countries the government sector is directly responsible for a large part of economic activity and, through its spending and resource mobilization, indirectly influences the way resources are used in the private sector. Substantial evidence exists that, in many cases, poor fiscal management has been a major factor underlying such problems as high inflation, a large current account deficit, and sluggish or negative output growth. In such circumstances, fiscal policy is usually at the center of an overall adjustment strategy.

Fiscal adjustment attacks these problems in two major ways: (1) through its impact on broad macroeconomic variables, such as the level and composition of aggregate demand, the national savings rate, and the growth of monetary aggregates; and (2) through its more microeconomic impact on the efficiency of resource allocation in the economy and the buildup of essential institutions and infrastructure.

Inflation

Government spending that is not financed by tax or nontax revenue can contribute to excess aggregate demand and thus inflation. This is particularly likely when government spending is financed through the creation of money. A certain level of monetary financing of the fiscal deficit may be noninflationary. Specifically, to the extent that growing economies need more money to facilitate transactions, that interest rates are falling (and other assets becoming less attractive), and that financial markets are developing (and the economy becoming increasingly monetized), the money supply can be expanded in a noninflationary way to meet increasing money demand. The government is said to be deriving resources from seigniorage when it finances a deficit in this way.

However, the scope for noninflationary financing is usually limited. Once the private sector is content with its money holdings, increasing the supply of money in the economy will encourage the private sector to spend more. This drives up prices until the desired ratio between money and spending is restored. To the extent that government borrowing from the banking sector contributes to an excessive rate of monetary growth, it will have inflationary implications. When a government finances its deficit by inflation-inducing monetary creation, it is said to collect an "inflation tax."³

In the short term, a government may be able to resort quite extensively to financing its operations from the inflation tax, since prices do not immediately adjust fully to an increase in money growth. However, over time, the scope for collecting the inflation tax is limited, since, when inflation rises, households and businesses will tend to decrease their real money holdings as they seek alternatives that hold their value better in such an environment. Moreover, high inflation can also have a negative impact on real tax revenue from explicit taxes if there are collection lags, and the net resource gain may not be great.

External Current Account

Residents of a country can spend more than the value of their production only by absorbing another economy's goods, that is, through a current account deficit in the balance of payments. Thus, if a government increases its spending, without taxes or other measures to restrain private sector demand, imports are liable to grow relative to exports of goods and services, and the current account tends to deteriorate. A simple accounting relationship can be established between fiscal and external current account balances. Gross national income (GNI) can be defined in terms of expenditure components or income uses (Equation 1).

GNI = Cp + Ip + G + X - M = Cp + Sp + T + R

(1)

where,

Cp = private consumption;

Ip = private investment;

G = government spending;

X = exports of goods and services;

M = imports of goods and services;

Sp = private savings;

T = government revenue; and

R = net current transfers to abroad.

Rearranging,

(Ip ­ Sp) + (G ­ T) = (M ­ X + R).

(2)

Equation 2 shows the external current account balance as the counterpart of the sum of the private sector's investment-savings balance and the fiscal deficit. Thus, a fiscal deficit must be matched by a domestic private sector that saves more than it invests and/or by an external current account deficit.⁴

Considerable caution is required in moving from the above accounting identity to the assumption that a simple causal relationship exists between fiscal and external deficits. A widening of the fiscal deficit may be reflected in an increase in the current account deficit, but it could also lead to a reduction in the private sector investment-savings balance through a crowding out of private investment (for example, when public and private investment are close substitutes, when the availability of credit to the private sector to finance investment is rationed, or when higher interest rates lower private investment). Similarly, an increase in the fiscal deficit may lead to a rise in the private savings rate, as individuals recognize that future tax burdens may be higher as a consequence of the need to service the prospective growth in public debt. Thus, the extent of linkage between fiscal and external deficits depends on any impact of fiscal policy on private sector savings and investment behavior; moreover, fiscal deficits may respond to, as well as influence, external balances.

Growth

There are two interrelated channels through which fiscal policy can affect the aggregate supply of an economy: (1) through its contribution to saving and investment, and thus on the long-run growth rate of capacity output, and (2) through its effects on the efficiency with which resources are allocated among competing uses, and thereby on the level of current output and future growth.⁵

To the extent that the government is a major source of dissaving in the economy (that is, its consumption exceeds its current revenue), it may have an adverse impact on growth. This would be particularly likely if the consumption is unrelated to the production of human capital and/or the maintenance of physical infrastructure. Less obviously, the government's taxing and spending decisions may change the way resources are used in the economy in a way that is detrimental to growth. An example of such effects would be taxation policies with adverse supply-side effects, such as exemptions or special tax rates that encourage investment in projects with low (or even negative) returns. Similarly, excessive marginal income tax rates may reduce the incentives for saving and high payroll tax rates may deter employment creation. The costs of such policies can be high.

Especially at times of economic recession, expansionary policies may increase output in the short run. The scope for expansionary fiscal policies in these circumstances is liable to be greatest in countries that had previously adopted conservative fiscal strategies. However, capacity constraints, a low responsiveness of domestic supply, and the inability to sustain an adverse balance of payments position are likely to limit the positive effects of demand expansion on output in most countries. Indeed, it is likely that overly expansionary fiscal policies may lead to increased distortions in the economy and, ultimately, a reduction in growth (see Box 1). For some countries, fiscal expansion could well prove contractionary even in the short run because financial market participants quickly raise interest rates in response to the expected higher rate of inflation and the prospect of financial instability.

Fiscal Adjustment to Ensure Sustainability

An important responsibility of economic policymakers is to ensure the longer-term viability of a noninflationary growth path for the economy. Governments may promote high growth in the short term, while sowing the seeds of future difficulties in terms of an unsustainable growth in public debt or the creation of an unfinanceable future external position. Thus, fiscal consolidation initiatives may be necessary in the short term to prevent the occurrence of an unsustainable fiscal position in the future. These issues may be considered in relation to the current account, government debt, and the impact of unfunded liabilities arising from current fiscal policies.

• Current account. A current account is unsustainable if it cannot be financed on a lasting basis with market-based capital inflows and it is not consistent with adequate growth, price stability, and the country's ability to service fully its external debt obligations. Assessing the medium-term sustainability of the current account is complex, requiring projections of such variables as trading partner demand, world prices of exports and imports, the future supply of exports and the demand for imports, market-based capital flows, the size of external debt and its servicing cost, and the prospects for private investment and savings. Since forced adjustment--such as would arise from a cutoff in foreign financing--is very costly, concerns over current account sustainability are typically a central rationale for fiscal stabilization.

• Government debt. Governments frequently resort to borrowing to finance their operations. The danger in relying on debt emerges when the ratio of public debt to gross domestic product (GDP) is allowed to rise over time. Such dangers are several and are a function of both the type of debt and the level of the debt-to-GDP ratio. Clearly, countries with high government debt have less scope to run deficits, which makes fiscal adjustment more urgent when macroeconomic imbalances begin to threaten stability. Nonetheless, they are more likely to run deficits, since their interest bill quickly becomes a large (and nondiscretionary) component of government expenditure. Issues related to the sustainability of government debt are further discussed in the following two sections.

Box 1. Adverse Consequences of Excessive Fiscal Expansion for Growth

Excess demand, originating from overly expansionary fiscal policies, often underlies problems of adjustment and growth. Such policies usually lead to inflation and a deterioration in the external current account. The government's response to this situation is often to impose domestic price controls, and trade and foreign exchange restrictions. These measures, however, exacerbate supply shortfalls, as resource misallocation increases and lack of imported inputs limits domestic capacity utilization and exports. The continued fiscal expansion leads to further deterioration in the underlying balance of payments, with accelerating inflation. Loss of confidence contributes to reduced capital inflows or capital flight, increasing the resource constraints. A vicious circle can then arise whereby these policies lead to an erosion of the tax base (particularly imports) and the difficulty of containing the fiscal deficit increases. At this point, the country has both problems of low, or negative, growth and underlying external adjustment problems. This scenario has close approximations to reality in many countries.

A high or rising debt level can, of itself, be a source of macroeconomic difficulties and create imbalances. High external debt increases the vulnerability of the fiscal position (and the exchange rate) to developments in international capital markets. Expectations of the future consequences of servicing substantial domestic debt--in particular, the prospect that a government might substantially increase the tax burden or might inflate debt away through money creation--could lead to a loss in confidence. This is related to the more general issue of credibility and the increasing importance attached not only to debt but also to fiscal deficits as indicators of the anti-inflationary resolve of policymakers.

At the extreme, government debt becomes unsustainable either if it is projected to rise indefinitely as a share of GDP or if the cost of debt servicing absorbs an excessive amount of resources. Assessing the sustainability of a government's debt position is not clear cut, but depends on projections of such variables as interest rates, economic growth rates, and government revenues and expenditures. However, sustainability is likely to become a particular problem when the growth of government interest payments exceeds that of government revenues.

• Unfunded liabilities. Often, governments introduce current fiscal policies that have limited short-term costs but that, over the medium to long term, may imply a substantial and possibly unsustainable increase in outlays. Sometimes the implications of such policies may be readily anticipated: pension commitments in the context of an expected increase in the elderly portion of the population are one obvious example. Often, there may be significant uncertainty as to whether a given policy may provoke unsustainably high growth in outlays (for example, the effect of commitments to hire all university graduates, or the uncertainty about the prospective increases in medical costs in a publicly funded medical insurance system). Policy actions may be necessary in the short run to avoid the need for drastic, and consequently more difficult, policy changes in the future.

Links to Other Policy Instruments

While the above discussion has focussed on the importance of fiscal policy for achieving macroeconomic policy objectives, it is important to see fiscal adjustment in the context of other macroeconomic policy instruments. Important interactions may be illustrated with respect to the exchange rate, monetary policy, and selective structural reforms.

• Exchange rate. Fiscal stabilization cannot be relied upon to achieve both internal and external objectives of adjustment. Relying entirely on fiscal retrenchment to eliminate a current account deficit may result in domestic problems such as unemployment and low growth. To avoid these imbalances, fiscal stabilization may need to be accompanied by policies that increase the price of goods that are, or could be, internationally traded (tradables) relative to the price of goods that can only be sold domestically (nontradables); in other words, policies to achieve a real exchange rate depreciation. Such policies allow a stronger current account balance for a given level of output and typically take the form of a devaluation of the nominal exchange rate.

  Fiscal policy initiatives both affect and are affected by exchange rate policies. A nominal depreciation will, itself, have a significant effect on the fiscal balance, and this can be either positive or negative, depending on the structure of the budget. If, for example, foreign-currency-based expenditures (such as interest payments on foreign debt) outweigh foreign-currency-based revenues (such as customs duties and oil revenues), the net effect of a depreciation would be to increase the fiscal deficit. Conversely, fiscal stabilization initiatives may affect the exchange rate, although the specific effects (in terms of an appreciation or depreciation) are likely to reflect the underlying economic situation (see Box 2).

  Fiscal policies are also likely to be necessary to support policies to adjust the real exchange rate. For example, under a fixed exchange rate system, a nominal devaluation will immediately increase the prices of tradable goods, but if the prices of nontradables also rise by a similar amount, the real exchange rate will not change. To prevent the price of nontradables from rising, it is usually necessary to introduce measures that dampen aggregate demand, of which the most important is often fiscal stabilization.

Box 2. The Exchange Rate Effects of Fiscal Policy

For industrial countries with developed capital markets and market-determined exchange rates the impact of fiscal policy on the exchange rate is ambiguous in the short run. In some cases, an increase in the deficit has been associated with an appreciation of the exchange rate, because fiscal expansion increased output, interest rates, imports, and capital flows; this assumes an unchanged stance of monetary policy and reflects the high mobility of capital among industrial countries. However, in other cases, fiscal deficits have been associated with a depreciating exchange rate. This may be explained by expansionary fiscal policies raising perceived exchange rate and political risks and lowering the credibility of both monetary and fiscal policies. A similar uncertainty surrounds the exchange rate impact of fiscal consolidation. In textbook models, fiscal contraction leads to an exchange rate depreciation. However, it is possible that fiscal contraction can lead to an appreciation of the exchange rate in the short run if the fiscal measures alleviate a significant fraction of the existing budgetary imbalance, are viewed as being permanent, and are adopted following a period of loose policies that have generated perceptions that domestic assets are risky and the exchange rate will continue to depreciate because of these policies. Over the long run, a sustained improvement in the fiscal balance that raises national saving and reduces the ratio of government debt to GDP will very likely lead to a real exchange rate appreciation. Thus, a country that saves more than its trading partners will ultimately find that its currency will strengthen relative to other currencies. In developing and transition economies with limited capital flows, fiscal deficits tend to be monetized to a much greater extent than in industrial countries. Consequently, fiscal consolidation (expansion) is much more unambiguously likely to lead to an exchange rate appreciation (depreciation) even in the short run.

• Monetary policy. Government borrowing from the banking system is usually a key factor influencing the overall rate of credit and money expansion. Consequently, fiscal adjustment is often a crucial element of policies to achieve monetary restraint. Failure to adjust the fiscal position can result either in an excessively expansionary monetary policy or in the achievement of monetary restraint at the cost of undesirable reductions in credit to the private sector. Fiscal policies may also be affected by the monetary policy stance. A tight monetary policy, perhaps pursued with an eye toward the maintenance of a particular nominal exchange rate, may (at least in the short run) result in high real interest rates that impinge on the cost of debt service to the government and the viability of the fiscal position.

• Structural policies. Structural adjustment policies are a central task of policymakers seeking to achieve higher rates of real economic growth or address problems of high unemployment. Such policies are most likely to achieve success in an environment of macroeconomic stability. In this broad sense, fiscal stabilization may be a necessary condition for structural adjustment. Specific structural measures may also require complementary changes in the fiscal system. For example, a reform of the tariff structure--vital for opening up an economy--is likely to reduce fiscal revenues and thus require compensating changes in other taxes. Similarly, the reform of the public enterprise sector may have important ramifications, often both positive and negative, for the budget, reflecting the importance of enterprises as sources of government tax revenue and recipients of transfers in many countries.

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³ This means that the government obtains resources at the expense of the reduced purchasing power of those with fixed nominal assets or incomes. As such persons are often among the poorer groups in society, the inflation tax is usually a highly inequitable means of financing government activities.
⁴ Similarly, a fiscal surplus must have a counterpart in the domestic private sector's investment-savings balance and/or in an external current account surplus.
⁵ The term growth is used in this section to refer to longer-term increases in output that reflect increases in aggregate supply.

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