Guidelines for Fiscal Adjustment

How Should the Fiscal Stance Be Assessed?

Given the size and complexity of most government budgets, it becomes important to develop broad indicators that convey a sense of the impact of fiscal policy on domestic demand and financial resources. Ideally, such indicators should reflect a comprehensive coverage of the government's activities and be easily derived from budget documents and other available statistical sources. The reality is often different; considerable efforts are frequently required to piece together accurate and conceptually appropriate indicators of the impact of fiscal policy. Usually, this requires analysis of policies effected both inside and outside the budget. Also, taking into account the way in which the budget affects, and is affected by, other economic variables can require important adjustments to official data.

A commonly used indicator to assess the stance of fiscal policy is the overall balance, which measures the difference between revenues and grants, and expenditure and net lending.6 This balance may be in surplus or deficit. As a starting point for analysis, an overall deficit (surplus) would suggest an expansionary (contractionary) fiscal stance on the basis that the negative impact of taxes and other revenue on aggregate demand is more (less) than offset by the positive effects of government spending. Developments in the overall balance over time, particularly when related to GDP (or GNI), provide an indication of the changing impact of the government sector on the economy.

While the overall balance is an important indicator for assessing fiscal policy, it is a measure that needs to be judged with caution. Since it offers a perspective on the aggregate demand effects of fiscal policy, it is, not surprisingly, deficient as an indicator of the impact of fiscal actions on other policy variables of concern (growth, monetary stance, sustainability, etc.). Moreover, as a simple indicator, it abstracts from the range of items that comprise government operations--importantly, the way the deficit is financed--as well as from the particular institutional and other factors that affect the impact of fiscal policy in any country. These complexities are discussed below in relation to the effect of the way a deficit is financed, special measures of fiscal impact that may complement the overall balance, the time frame of analysis, and possible alternative definitions of the government sector and fiscal balance.

When attention shifts to the supply side of the economy, the structure of fiscal policy takes on greater significance, and simple indicators of fiscal policy stance become less useful. Indeed, structural fiscal adjustment may be needed even when stabilization is not an issue. This is because high taxes can foster a misallocation of resources and create work and savings disincentives, and government spending at the margin may be less productive than private spending. Issues relating to the appropriate structure of fiscal adjustment are addressed in the last section.

Fiscal Impact of Alternative Methods of Deficit Financing

A deficit may be financed from domestic (bank and nonbank) or external sources. Any assessment of fiscal policy stance would need to take account of the way the deficit is financed, since each method of financing has particular macroeconomic effects and costs. However, for countries without capital controls there is little distinction between domestic and foreign nonbank financing--governments cannot control (or in most cases monitor) the purchase of government securities or the capital flows that occur in response to changes in domestic interest rates.

Other Measures Used to Assess the Fiscal Stance

A number of other fiscal indicators are often used to provide additional insights into the impact of a government's fiscal policy stance. Most relate to special issues or circumstances and are only partial approaches and indicators for assessing complex situations. The following provides some examples of commonly used measures:

The Sensitivity of a Fiscal Assessment to the Time Frame of Analysis

The short-term fiscal balance can prove misleading for the purpose of assessing the sustainability of a government's fiscal position. This may be illustrated by the following problems:

Definition of Government Accounts for Macroeconomic Analysis

Efforts at assessing fiscal policy lead to important questions about the institutions comprising the government, the time when a fiscal transaction impacts on the economy, and the transactions to be included when determining the overall fiscal balance.12

Coverage of Government Operations

Fiscal policy (namely the use of the government's taxing, spending, and borrowing powers to attain public objectives) may be effected by different levels of government and through a range of institutions. Definitions of government are best distinguished by the function performed, rather than by legal or institutional criteria. On this basis, the following government sectors may be distinguished, with correspondingly different measures of fiscal deficits:

In principle, an assessment of fiscal policy should be based on the most comprehensive definition of government possible. Considering only the central government fiscal balance may provide a distorted picture of the fiscal stance when subnational fiscal authorities and a social security fund carry on substantial fiscal operations, or when quasi-fiscal activities are important. At the same time, for fiscal assessment to be of the most value, it should be based on data that are regularly and quickly available. This need, combined with the view that central government policies are easier to change quickly, creates a tendency to focus analysis on developments in the central government accounts. Also, if certain levels of government are constrained in their borrowing capacity and thus forced to run balanced budgets, it may be possible to abstract from these levels of government in considering the aggregate demand effects of fiscal developments. Reconciling these conflicting perspectives requires that systems be established to carry out the periodic monitoring of financial developments at subnational levels of government and in the public enterprise sector. It also requires an attempt to measure at least the most important types of quasi-fiscal activities.

Timing of the Impact of Fiscal Transactions

Normally, governments commit resources before they are actually disbursed on a cash basis. Some tax liabilities may also accrue for a considerable period before a taxpayer has to make a payment. This gives rise to the question as to whether the fiscal balance is to be assessed on a commitment basis--since these implicit transactions may affect activity in the economy--or only on the basis of cash transactions (and the cash balance).13 A cash-based measure of the fiscal balance has the advantage of emphasizing links with financial developments, particularly in the monetary accounts. In a number of countries, however, governments have resorted to not meeting their commitment obligations, either due to a lack of liquidity and/or to meet targets for cash-based deficit reduction. A cash-based deficit will then underestimate the extent of a government's pre-emption of real resources. Indeed, when the arrears are to enterprises, which, in turn, borrow from the banking system, a cash-based deficit concept will also underestimate the government's contribution to the growth of monetary aggregates and demand. In these circumstances, where possible, the budget should be presented on both a cash and a commitments basis, with changes in arrears providing the principal link between the two concepts.14

Box 3. Quasi-Fiscal Activities of Public Financial Institutions

In many countries, central banks and other public financial institutions (PFIs) play an important role in fiscal policy. By undertaking financial transactions that serve the same role as taxes and subsidies, they increase the effective size of the fiscal deficit. These so-called quasi-fiscal activities (QFAs) can have a significant allocative and budgetary impact in many countries.

In the case of a central bank, the majority of QFAs arise from its dual roles as regulator of the exchange and financial systems and as the banker to the government. QFAs can involve multiple exchange rate arrangements (typically a tax on exporters and a subsidy to importers), exchange rate guarantees (a contingent subsidy to the borrower of foreign exchange), interest rate subsidies and sectoral credit ceilings, central bank rescue operations, and lending to the central government at below-market rates. Other PFIs often undertake QFAs by imposing restrictions on financial markets (such as interest rate subsidies and credit ceilings), or by providing government-mandated special treatment for specific classes of borrowers (for example, the agricultural sector) and lenders.

There are a variety of reasons why central banks and other PFIs may engage in QFAs. QFAs may allow the government to hide what should essentially be considered budgetary activities in the accounts of PFIs. Such QFAs may not receive equivalent legislative or parliamentary scrutiny compared to budgetary operations. Another rationale for some QFAs is that it may be more convenient to administer them relative to budgetary operations.

Clearly, QFAs ought to be explicitly considered in the formulation of fiscal programs. As a first step, any quantifiable QFAs should be added to the fiscal balance to provide a broader and more appropriate measure of the deficit. To the extent possible, these should then be transformed into normal budgetary operations by replacing quasi-fiscal taxes and subsidies with explicit taxes and subsidies. While this would bring them out into the open, their distortionary effects on the economy would remain. More fundamental action--namely, structural reform--is required in order to achieve a long-term solution.

Defining the "Overall Fiscal Balance"

On a cash basis, total incomings and outgoings from the budget must always balance. A deficit (or surplus) is determined by drawing a balance among a subset of receipts and payments (classified "above the line"), which are then financed by other transactions (shown "below the line"). The delineation is based on the analytical needs sought from the measure of the fiscal balance.

As noted earlier, a common measure of the fiscal balance is the overall balance, namely, the difference between revenue and grants, and expenditure and net lending (all of which are thus above the line).15 Viewed from below the line, a deficit in the overall balance is financed by a drawdown in cash assets (and use of other financial assets acquired for liquidity purposes) and by an increase in the government's debt liabilities through borrowing from external and domestic sources--the latter encompassing nonbank and bank financing. This definition emphasizes the extent to which the financing of government expenditure and net lending requires the assumption of debt obligations for future repayment and/or a rundown in the government's holding of liquid financial assets.

There are at least two areas in which this definition can be adapted.


6 See International Monetary Fund (1986, pp. 106108). The Manual uses the term "lending minus repayments" rather than "net lending."
7 The demand effects of deficits financed by debt issuance may, to a limited extent, be offset by increases in private sector savings in anticipation of future taxation to finance debt service.
8 If nominal interest rates on government debt are not greater than nominal GDP growth, a primary surplus will imply that the share of government debt in GDP will fall.
9 In its World Economic Outlook exercise, the IMF also provides an estimate of the fiscal impulse, the initial stimulus to aggregate demand arising from fiscal policy from whatever source, whether discretionary or otherwise, during a given period.
10 This indicator has been criticized for imparting an inflationary bias to fiscal policy, since unexpected inflation may reduce the inflation-adjusted deficit substantially. Moreover, it assumes that bondholders will save 100 percent of the inflationary component of their nominal interest earnings. While flawed, the operational deficit concept is a useful complementary indicator of fiscal policy in a high inflation rate environment.
11 A further illustration of partial approaches would be the exclusion of the surplus of a public pension fund that did not operate on a pay-as-you-go (PAYG) basis and accumulated funds from contributors in excess of payouts to current retirees when assessing the sustainability of the central government's deficit.
12 These issues are addressed in some detail. See International Monetary Fund, (1986, pp. 106108).
13 Even when expenditure is measured on a commitments basis, revenue is normally calculated on the basis of actual receipts. The reason is that estimates of unpaid tax liability are usually much higher than the amount that will actually be collected.
14 Arrears are usually defined as payments which have been overdue for a period greater than the lag normally associated with a country's payments process. There may sometimes also be a significant increase in budgetary commitments that, while not having yet given rise to arrears, may still lead to a divergence between the magnitude of recorded outlays on a cash and commitments basis.
15 Net lending (above the line) includes only transactions in debt and equity claims undertaken for purposes of public policy, rather than for liquidity management.
16 Since government investment outlays generate physical assets, inclusion of the acquisition of such financial assets above the line contributes to a uniformity of treatment with regard to asset acquisition.

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