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.
- Monetization of deficits. As previously discussed, government borrowing from the central bank directly increases the monetary base, and thus the money supply, and may be a source of inflationary pressure. Reliance on commercial bank financing may have similar effects if banks are not forced to limit credit to other borrowers. Where overall credit ceilings apply, borrowing from banks may not be monetized but may absorb credit that could otherwise be available to the private sector.
- Reliance on nonbank financing. The scope for domestic nonbank financing is usually a function of how far capital markets have developed and whether there is public demand for government bonds. In addition to market-based security purchases, nonbank borrowing may reflect direct government intervention in the capital market. Thus, the government may require public sector institutions to hold government bonds for liquidity management purposes or may mandate heavily subsidized government savings programs. Such interference in the financial intermediation system is likely to adversely affect the efficient use of financial savings.
Deficits financed by borrowing from the nonbank private sector may have a more limited impact on aggregate demand than direct monetary financing, insofar as there is a compensating reduction in spending by the private sector.7 Government borrowing may increase domestic interest rates and reduce private investment; alternatively, when interest rates are controlled, private investment may be more directly reduced through credit rationing. Thus, while nonbank borrowing is likely to have the considerable advantage of being less inflationary than monetary financing, this may well come at the cost of "crowding out" productive private sector activities.
- Borrowing from abroad. Liquid resources obtained from abroad can be used to expand domestic demand as well as imports. However, to the extent that external borrowing facilitates the importation of additional resources from the rest of the world, the impact of a deficit on excess demand for domestic goods and services is reduced. Concessionality is important: for developing countries, foreign financing often contains a grant element, and the larger it is, the more the government can borrow without jeopardizing the sustainability of the fiscal position. In effect, concessionality reduces the effective interest rate. External grants are the ultimate form of concessional financing, although they are formally treated as revenue. Reliance on nonconcessional external financing leads to an accumulation of debt, which needs to be serviced and eventually repaid; it makes the economy potentially vulnerable to changes in the exchange rate and world interest rates. Such financing also facilitates the maintenance of a more appreciated exchange rate, damaging exports and encouraging imports. Deficits financed in this way, therefore, need to be assessed in the context of the external debt position of the country, the medium-term balance of payments prospects, the terms under which borrowing takes place, and the uses to which external borrowing may be put.
- Accumulation of arrears. Delays in payments on debt service, or on goods and services purchased, are considered a particularly costly means of financing budgetary commitments. Such arrears are likely to have similar macroeconomic consequences to other forms of public borrowing, as well as jeopardizing future financing, government credibility, and the integrity of the budgetary system. For example, the impact on prices and the balance of payments would be essentially the same whether a deficit is financed by borrowing from the domestic banking system or by accumulating domestic arrears to public enterprises and the private sector, which then borrow from the banking system.
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 current fiscal balance represents the difference between current revenue and current expenditure. It provides a measure of the government's contribution to national savings. When positive, it suggests that the government can at least finance consumption from its own revenue. A fundamental concern with this measure is the implicit assumption that all current expenditure is of a consumption nature that does not contribute to growth. By implication, the measure also assumes that all outlays categorized as investment do not have the attribute of being consumption in character. Yet many examples can be found of unproductive capital spending that does not augment the real capital stock of the economy (or does so inefficiently); conversely, some forms of current expenditure, for example, spending on health and education or on the operation and maintenance of infrastructure, may be highly productive and contribute either to human capital formation or to the slowing of capital depreciation.
- The primary balance excludes interest payments from expenditure. It can be said to provide an indicator of current fiscal effort, since interest payments are predetermined by the size of previous deficits. For countries with a large outstanding public debt relative to GDP, achieving a primary surplus is normally viewed as important, being usually necessary (though not sufficient) for a reduction in the debt/GDP ratio.8
- Cyclically adjusted or structural balances seek to provide a measure of the fiscal position that is net of the impact of macroeconomic developments on the budget. This approach takes account of the fact that, over the course of the business cycle, revenues are likely to be lower (and such expenditure as unemployment insurance benefits higher) at the trough of the cycle. Thus, a higher fiscal deficit cannot always be attributed to a loosening of the fiscal stance, but may simply reflect that the economy is moving into a trough. Essentially, calculation of a cyclically adjusted or structural balance involves an estimation of what revenues and cyclically adjusted expenditure (and thus the deficit) would be if the economy were at its potential or--for some measures of the structural balance--its trend output, rather than its actual output.9
The usefulness of these indicators is limited by difficulties in identifying potential and trend output, and, consequently, in distinguishing cyclical and underlying elements of the fiscal deficit. Moreover, it is important to distinguish normal tendencies in the business cycle from those arising from external developments. Particularly, when the cyclical downturn reflects adverse external developments, the scope for accepting a larger deficit may be limited. Unless there has been a substantial prior accumulation of international reserves, a negative external shock is likely to require a fiscal contraction to reduce absorption and facilitate adjustment to changed production and income prospects.
- The domestic fiscal balance includes only those components of the conventional deficit that arise from transactions with the domestic economy and omits those transactions directly affecting the balance of payments. The measure is used to identify the direct expansionary impact of government on the domestic economy. This has proved a particularly useful indicator for some oil producing economies, where government revenues from exports do not reduce domestic absorption.
- The operational balance has been devised to take account of the fact that the high interest rates paid on government debt during times of very high inflation effectively compensate purchasers of government debt for the reduced real value of the debt principal caused by inflation. In such inflationary circumstances, both the ratios of interest outlays and the deficit, relative to GDP, are very high; a fortiori, the deficit-to-GDP ratio significantly overstates the extent of the deficit that would prevail in a low inflation rate environment. The "operational balance" excludes that part of interest outlays that compensate debt holders for the impact of actual inflation; in effect, this component of interest is treated as though it were amortization in order to maintain an unchanged real value of the debt. Use of the operational deficit concept facilitates an analysis of the underlying stance of fiscal policy by adjusting for this inflation-interest rate nexus.10
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:
- The annual balance may show receipts from privatization and the sale of other assets as revenues, and thus mask a higher deficit exclusive of such receipts. Receipts from market-based privatization sales do not change a government's net worth if it is assumed that the cash receipts equal the market value of the privatized assets. Indeed, the divestiture of government assets may imply that in subsequent periods revenues will be diminished to the extent that the receipts from the asset sale have not been reinvested in an equivalent yielding asset (or, to the same effect, used to repay outstanding government debt). However, insofar as privatization leads to improved economic performance, it may boost the tax base. More generally, in evaluating the fiscal position at a given point in time, it is necessary to be particularly cautious in interpreting revenues or outlays that arise from changes in the government's net wealth position.
- The annual fiscal balance includes both revenues that are associated with a future obligation by the government to make payments (such as social security expenditures) and expenditures that arise from previous obligations of this type. Government guarantees may also have no costs in the present but could imply large future outlays.
Such problems have led to a substantial academic literature exploring the replacement of the annual deficit with a measure of changes in the government's discounted net worth. Operationally, such measures have proven difficult, and more partial approaches have been followed to take account of these factors. For example, where significant, privatization receipts should be excluded from revenue when assessing the appropriateness of the fiscal stance; that is, they should be treated as contributing to the financing of the overall deficit. Similarly, fiscal analysts often assess the magnitude, probability, and likely timing of contingent liabilities, including government guarantees that may well be called upon in the future.11
Consideration of the annual fiscal balance may also need to be supplemented by longer-term analysis to assess the future impact of current fiscal policies. For example, countries with aging populations are likely to find that pension schemes financed on a pay-as-you-go basis are placed under growing strain; increasing expenditure needs may require high payroll taxes and possibly budgetary transfers. A longer-term assessment would provide a basis for assessing such budgetary implications and guiding possible changes in underlying policies.
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:
- Central government refers to the activities of the central authority of a country. Importantly, transactions at this level should not only reflect the legal budget of the central government but also the fiscal actions of any extrabudgetary funds or autonomous agencies relevant to central government policies or under the central authorities' effective control.
- General government includes, in addition to the central government, the budgetary and extrabudgetary activities of governments operating only in parts of the country (state and local governments, etc.). Note that social security funds form part of the level of government at which they operate. Based on a functional definition of government and fiscal policy, the following two further sets of activities may be considered in defining alternative measures of the deficit:
- Nonfinancial public sector enterprises (NFPEs) are government-owned and/or controlled corporations whose activities may be significantly influenced by nonmarket factors, often including application of a "soft budget constraint." The operational balance of NFPEs and their investments can be consolidated with the activities of the general government to form a broad measure of the fiscal operations of the nonfinancial public sector.
- Quasi-fiscal operations of public financial institutions are tax and subsidy operations that may take place through the activities of this sector, the most important of which are undertaken by the central bank. As discussed in Box 3, such activities may have a fiscal impact comparable to that of more traditionally defined government activities and measures.
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.
- External grants. These are included with other government revenue on the grounds that they do not add to debt and may finance expenditures that would otherwise not take place. However, grants reflect discretionary financing by donors that can change significantly from year to year. Their inclusion may mask their possible impermanence and may elicit a structural increase in expenditure, which may subsequently prove difficult to reverse. Consequently, in assessing the fiscal position, the deficit is normally calculated both inclusive and exclusive of grants.
- Net lending. By placing net lending above the line, there is an asymmetry between the treatment of changes in government financial assets (acquired for policy purposes) and liabilities. In effect, the former are placed above the line, the latter below. Net lending is primarily composed of direct capital infusions of funds to public (and sometimes private) enterprises (for example, when the government acquires equity) and of government credit programs undertaken for policy purposes.16 Given its implicit subsidy element and the possibility that some of the loans will never be repaid, net lending cannot be defined as pure financial intermediation. This usually justifies its treatment as a deficit-determining item above the line. However, a deficit concept that was based on determining changes in a government's net financial worth or indebtedness would place net lending activities below the line. Emphasis on the government's net financial worth would support placing privatization receipts below the line, with some measure of the reduced value of equity holdings offsetting the increase in cash deposits. This would be consistent with the treatment recommended in the section on the sensitivity of a fiscal assessment to the time frame of analysis.
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.