## ASSESSING FISCAL SPACE: AN INITIAL CONSISTENT SET OF CONSIDERATIONS

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---

### Executive summary — concept and purpose
- Fiscal space: a multi-dimensional concept reflecting whether a government can raise spending or lower taxes without endangering market access and debt sustainability.
- Determination requires a comprehensive, forward-looking, dynamic assessment considering:
  - initial economic and structural conditions;
  - market access and risk of sharply increasing funding costs;
  - the level and trajectory of public debt and financing needs;
  - present and future financing needs and contingent liabilities;
  - dynamic analysis of liquidity and solvency under alternative policies and shocks;
  - country-specific factors such as credibility and implementation capacity.
- Objective of the note: bring together Fund staff approaches and indicators to outline a consistent set of considerations to inform assessments of fiscal space, especially for advanced and emerging markets, and to facilitate consistency in country team assessments in surveillance.
- Prepared by an interdepartmental working group; approved November 18, 2016.

### Framework and tools
- Core operational framework: the debt sustainability framework, complemented by:
  - indicators developed by the Fiscal Affairs Department (FAD) (used in the internal Vulnerability Exercise and Fiscal Monitors);
  - fiscal stress tests and probabilistic approaches proposed in IMF (2016);
  - scenario analysis and general equilibrium modeling approaches.
- No single indicator or approach covers all relevant factors; assessment requires judgment informed by a broad range of tools.

### Four-stage approach to assessing fiscal space
- Stage 1 — Setting the macroeconomic stage:
  - Clarify cyclical and external conditions and gaps (structural reforms, infrastructure, balance sheet repair) that affect the economic impact of fiscal actions.
- Stage 2 — Hierarchical indicators of fiscal space:
  - (i) Availability of financing on favorable terms and the risk of market perceptions sharply increasing funding costs.
  - (ii) Sustainability of the level and trajectory of public debt and financing needs over the medium term under both the baseline and stress tests.
  - (iii) Realism of medium and long-term adjustment assumptions needed to stabilize debt or achieve prudent debt ratios (including expected increases in health and pension spending).
- Stage 3 — Dynamic exploration:
  - Simulate discretionary fiscal policy experiments (expansion or contraction relative to baseline) under different assumptions about monetary policy settings and market reactions, and map implications for macro variables, debt levels, and financing needs.
- Stage 4 — Staff judgment:
  - Integrate signals from Stages 1–3 and country-specific factors (including compliance with and adequacy of existing fiscal frameworks) to arrive at a final assessment of the degree of fiscal space.

### Role of fiscal rules and credibility
- Well-designed fiscal rules help anchor fiscal credibility while allowing use of fiscal space to smooth shocks and are especially important for currency unions.
- Desirable features:
  - Support explicit medium-term objectives while leaving flexibility for shocks or exceptional circumstances.
- Limitations and risks:
  - Some risks (e.g., protracted demand shortfalls and deflationary pressures) are hard to incorporate ex ante into rules.
  - Deviations from medium-term commitments risk sudden and very high costs in lost credibility, especially in emerging markets (e.g., higher financing costs or difficulty of market access).
- Staff actions where discrepancies exist between analytical assessment and fiscal frameworks:
  - evaluate appropriateness of fiscal rules and frameworks;
  - consider necessary reforms in bilateral surveillance;
  - assess scope for strengthening rule design and effectiveness under alternative scenarios and make policy recommendations as warranted.
- Planned work: new cross-country analytical work on desirable features of fiscal rules.

### Policy emphasis: growth-friendly tax and expenditure policies
- Policy objective: regardless of fiscal space assessment, aim for growth-friendly tax and expenditure policies to support work and investment incentives, human capital accumulation, and productivity growth.
- Budget-neutral, growth-friendly reform options (high-level):
  - Revenue-side reforms:
    - Shift from direct to indirect taxes while containing regressivity through better targeting of spending.
    - Base-broadening measures (rationalizing tax exemptions and preferential regimes).
    - Improve revenue administration (risk management, large taxpayer units, simplification of laws and procedures).
  - Expenditure-side reforms and priorities:
    - Target public expenditure toward areas with high multipliers: infrastructure, education, health, R&D, and key public goods.
    - Ensure public investment management processes to translate investment into productive capital and growth.
  - When consolidation is required:
    - Focus on measures with lower fiscal multipliers, improve spending efficiency, and limit distortionary revenue measures.
    - Expenditure reviews can help identify rationalization and efficiency gains.
- Empirical facts and administrative points:
  - Spending on wages, subsidies and social benefits accounts for around three-quarters of total spending in advanced and emerging economies.
  - In advanced economies, only one-fifth of total spending on family benefits was means-tested in 2011.
  - In health sector efficiency estimates, at least 20-40 percent of health (context truncated in source).

### Box 1 — Efficiency, subsidies, and tax options (key figures)
- Public investment inefficiency: the average country loses about 30 percent of the value of its public investment to inefficiencies in the investment process.
- Energy subsidies:
  - 2015 estimate: spending on energy subsidies (on a post-tax basis) was estimated at US$5.3 trillion (or 6½ percent of global GDP).
  - Carbon or congestion taxes could potentially generate significant revenue gains, "as much as 2.9 percent of global GDP".
- Health and education efficiency:
  - Scope for substantial gains in health indicators at current spending levels (Grigoli and Kapsoli (2013)).
  - Example of per-student financing formula (Netherlands) to align wage costs with number of students (IMF (2014b)).

### Conceptualization and measurement approaches
- Common practical formulations of fiscal space:
  - Debt sustainability: difference between current public debt and a specified threshold, determined by future fiscal balance adjustments, vulnerability to shocks (proxied by income levels), and realism of needed adjustments based on track record.
  - Financing scope: ability to finance deficits without a sharp spike in funding costs or excessive crowding-out of private investment.
- Approaches summarized (Box 2):
  - Fiscal gap approach.
  - VAR-based approach.
  - General equilibrium models.
  - Fiscal reaction function approach.
  - Intertemporal budget constraint / stationarity and co-integration tests.

### Debt-growth trade-offs and scenario considerations
- Key focus areas when evaluating discretionary fiscal policy:
  - Extent of slack in the economy and spending needs (and hence likely multipliers).
  - Marginal cost of financing new spending.
  - Extent to which other macro policy instruments, including monetary policy and exchange rate adjustment, may be constrained.
- Counterfactuals: include risk that lack of fiscal action could leave the economy vulnerable to a downturn, producing worse fiscal outcomes via weaker growth and materialization of contingent liabilities.
- Fiscal sustainability–growth tradeoff more favorable in countries with:
  - Larger output gaps.
  - More efficient public spending.
  - Lower funding costs.

### Stage 4 — Staff judgment and contextual factors
- Final assessment combines Stages 1–3 plus country-specific considerations including:
  - Fiscal frameworks:
    - Rules support credibility and market access and thus fiscal space.
    - Recommendation: staff should regularly conduct Stages 1–3 analyses, compare results to fiscal framework requirements, highlight tradeoffs, evaluate appropriateness of frameworks, and consider reforms where significant discrepancies persist.
  - Currency unions:
    - Lack of independent monetary policy complicates policy mix; temporary deviations from rules require multilateral negotiations; intra-union spillovers complicate assessment of fiscal multipliers.
  - Uncertainty about indicator results:
    - Modeling uncertainty from assumptions about historic shocks, multipliers, risk premium, contingent liabilities, structural breaks, and market-reaction thresholds affects sustainability and fiscal space assessments.

### Conclusions and recommended policy orientation
- The note presents a consistent, four-step approach to fiscal space assessment:
  1. Situate the country in terms of initial conditions (cyclical position and structural gaps).
  2. Assess indicators of fiscal sustainability related to market access, level of debt, and gross financing needs under staff baseline and stress tests.
  3. Simulate effects of discretionary fiscal policies and alternative scenarios on fiscal sustainability, growth, inflation, and other macro variables.
  4. Use these inputs to inform staff assessments of fiscal space, incorporating country-specific factors not captured by generic criteria.
- Applicability: with adjustments, the framework could apply to the entire Fund membership; logic remains relevant despite data limitations in low-income countries and economies without market access.
- Policy options reiterated:
  - (i) Strengthen incentives for work and investment in human capital by reforming labor taxes and social benefits (reducing “tax wedges”).
  - (ii) Encourage private investments and R&D by reforming corporate income taxes and well-targeted tax incentives.
  - (iii) Raise productive capacity through efficient public investment, especially in infrastructure.
  - (iv) Promote human capital accumulation through broad access to education and health care.

### Issues for further work
- Definition of benchmarks:
  - Appropriate benchmarks for fiscal indicators remain debated, including for advanced economies and reserve currency issuers.
  - Initial approach: relate thresholds to likelihood of fiscal stress (signal approach used in DSA and VE).
- Behavior of risk premium:
  - Risk premia can move sharply and non-linearly under tightening global liquidity, heightened risk aversion, worsening macro fiscal indicators, discretionary fiscal policies, or repeated breach of fiscal rules.
  - Stage 3 can examine alternative scenarios with different risk premia based on country historical experience; more systematic modeling of risk premia behavior is needed.
- Design of fiscal rules:
  - FAD plans cross-country analytical work on desirable features of fiscal rules based on historical experience.
- Framework will be updated based on implementation experience and new metrics developed by Fund staff.

### Annex I — Selected indicators (summary highlights)
- Stage 1 potential indicators:
  - EBA Current Account Gap; EBA Domestic Fiscal Policy Gap.
  - Structural Reform Related Gaps: third-party indicators (e.g., World Bank Doing Business, OECD indices).
  - Real public capital stock per capita: series expressed in constant international 2005 prices (PPP).
  - Efficiency of public investment: PIMA score ranges between 0 and 10.
- Stage 2 potential indicators:
  - Financing and debt burden indicators: MAC DSA framework calibration uses the signal approach separately for EMs and AEs.
  - Definition of debt distress events:
    - For EMs: Default; Restructuring and rescheduling; MF financing.
    - For AEs: Default (S&P definition); Restructuring and rescheduling; IMF financing in excess of 100 percent of quota; Inflation greater than 35 percent per annum; Sovereign spreads greater than 1000 basis points or 2 standard deviations from the country average.
  - Signal-approach benchmarks:
    - Benchmarks derived by minimizing missed crises and false alarms; medians computed separately for AEs and EMs.
    - A noise-to-signal ratio below 100 suggests the indicator is an efficient predictor.
    - Debt level benchmark increased by about 20 percent for higher scrutiny group: to 70 for EMs and 85 for AEs.
  - Probability of Breaching Debt Benchmark:
    - Calculated using simulated distributions of future debt outcomes via stochastic simulations of macroeconomic and fiscal shocks; yields probabilities that public debt exceeds a threshold over projection period.
  - Realism of Adjustment Required to Stabilize Debt:
    - Cross-country guidance: closer scrutiny required if (i) planned cyclically-adjusted primary fiscal adjustment over any three years during projection horizon is larger than 3 percent of GDP; or (ii) average of cyclically adjusted primary balance for any consecutive 3-year period during projection horizon is greater than 3.5 percent of GDP.
  - Long-Term Adjustment Need:
    - Measures change in cyclically-adjusted primary balance needed between now and 2020 (and maintained until 2030) to reduce public debt to 60 and 40 percent of GDP by 2030 for advanced and emerging economies respectively while offsetting expected increases in age-related spending.
    - Net debt is used for Australia, Canada and Japan. For Japan, the net debt target is 80 percent, which corresponds to a gross debt of 200 percent.

*Prepared by an interdepartmental working group; approved November 18, 2016. Source: EXECUTIVE SUMMARY and excerpts of "Assessing Fiscal Space: An Initial Consistent Set of Considerations."*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Concept and purpose
- Fiscal space is a multi-dimensional concept reflecting whether a government can raise spending or lower taxes without endangering market access and debt sustainability.
- Determining fiscal space requires a comprehensive, forward-looking, dynamic assessment considering:
  - initial economic and structural conditions;
  - market access and risk of sharply increasing funding costs;
  - the level and trajectory of public debt and financing needs;
  - present and future financing needs and contingent liabilities;
  - dynamic analysis of liquidity and solvency under alternative policies and shocks;
  - country-specific factors such as credibility and implementation capacity.
- The note’s objective: bring together Fund staff approaches and indicators to outline a consistent set of considerations to inform assessments of fiscal space, especially for advanced and emerging markets, and to facilitate consistency in country team assessments in surveillance.

### Framework and tools
- The Fund’s core operational framework is the debt sustainability framework, complemented by:
  - indicators developed by the Fiscal Affairs Department (FAD) (used in the internal Vulnerability Exercise and Fiscal Monitors);
  - fiscal stress tests and probabilistic approaches proposed in IMF (2016);
  - scenario analysis and general equilibrium modeling approaches.
- No single indicator or approach covers all relevant factors; assessment requires judgment informed by a broad range of tools.

### Four-stage approach to assessing fiscal space
- Stage 1 — Setting the macroeconomic stage:
  - Clarify cyclical and external conditions and gaps, including those related to structural reforms, infrastructure, and balance sheet repair, which affect the economic impact of fiscal actions.
- Stage 2 — Hierarchical indicators of fiscal space:
  - (i) Availability of financing on favorable terms and the risk of market perceptions sharply increasing funding costs.
  - (ii) Sustainability of the level and trajectory of public debt and financing needs over the medium term under both the baseline and stress tests.
  - (iii) Realism of medium and long-term adjustment assumptions needed to stabilize debt or achieve prudent debt ratios (including expected increases in health and pension spending).
- Stage 3 — Dynamic exploration:
  - Simulate discretionary fiscal policy experiments (expansion or contraction relative to baseline) under different assumptions about monetary policy settings and market reactions, and map implications for macro variables, debt levels, and financing needs.
- Stage 4 — Staff judgment:
  - Integrate signals from Stages 1–3 and country-specific factors (including compliance with and adequacy of existing fiscal frameworks) to arrive at a final assessment of the degree of fiscal space.

### Role of fiscal rules and credibility
- Well-designed fiscal rules help anchor fiscal credibility while allowing use of fiscal space to smooth shocks and are especially important for currency unions.
- Desirable features:
  - Support explicit medium-term objectives while leaving flexibility for shocks or exceptional circumstances.
- Limitations:
  - Some risks (e.g., protracted demand shortfalls and deflationary pressures) are hard to incorporate ex ante into rules.
  - Deviations from medium-term commitments risk sudden and very high costs in lost credibility, especially in emerging markets (e.g., higher financing costs or difficulty of market access).
- Where significant discrepancies exist between Stages 1–3 assessments and the fiscal framework, staff should:
  - evaluate the appropriateness of the fiscal rules and frameworks;
  - consider necessary reforms in bilateral surveillance;
  - assess scope for strengthening rule design and effectiveness under alternative scenarios and make policy recommendations as warranted.
- Work planned: new cross-country analytical work on desirable features of fiscal rules.

### Scope and limitations of the note
- The note does not prescribe when fiscal space should be used; use depends on country-specific circumstances and the appropriate fiscal stance.
- The note provides a set of tools to assess available fiscal space in a broadly comparable way across countries to inform policymaker decisions.

### Policy emphasis: growth-friendly tax and expenditure policies
- Regardless of fiscal space assessment, countries should aim for growth-friendly tax and expenditure policies to support work and investment incentives, human capital accumulation, and productivity growth (referenced IMF (2015c)).
- Budget-neutral, growth-friendly reform options (Box 1 highlights):
  - Revenue-side reforms:
    - Shift from direct to indirect taxes while containing regressivity through better targeting of spending.
    - Base-broadening measures (rationalizing tax exemptions and preferential regimes).
    - Improve revenue administration (risk management, large taxpayer units, simplification of laws and procedures).
  - Expenditure-side reforms and priorities:
    - Target public expenditure toward areas with high multipliers: infrastructure, education, health, R&D, and key public goods.
    - Ensure public investment management processes to translate investment into productive capital and growth.
  - When consolidation is required:
    - Focus on measures with lower fiscal multipliers, improve spending efficiency, and limit distortionary revenue measures.
    - Expenditure reviews can help identify rationalization and efficiency gains.
- Empirical/administrative facts cited:
  - Spending on wages, subsidies and social benefits accounts for around three-quarters of total spending in advanced and emerging economies.
  - In advanced economies, only one-fifth of total spending on family benefits was means-tested in 2011.
  - In health sector efficiency estimates, at least 20-40 percent of health (context truncated in source).

### Implementation and evolution
- The proposed set of considerations will evolve with further experience, research, and feedback.
- The framework is intended to support ongoing Fund surveillance and policy advice, informing discussions of appropriate fiscal stance across the economic cycle (e.g., scope for fiscal support given slack, deflationary pressures, diminished gains from monetary policy, and structural reform priorities, or the pace of fiscal withdrawal or buffer building).

*Prepared by an interdepartmental working group; approved November 18, 2016. Source: EXECUTIVE SUMMARY of "Assessing Fiscal Space: An Initial Consistent Set of Considerations."*

### Box 1. Budget Neutral Growth-Friendly Fiscal Reforms (concluded)

### Box 1. Budget Neutral Growth-Friendly Fiscal Reforms (concluded)

### Efficiency gains and expenditure reallocation
- Health: spending is typically wasted (World Health Organization (2010)), and there is scope for substantial gains in health indicators at current levels of spending (Grigoli and Kapsoli (2013)).
- Education: implementing a per-student financing formula such as in the Netherlands could ensure that wage costs remain in line with the number of students and generate savings (IMF (2014b)).
- Public investment: the average country loses about 30 percent of the value of its public investment to inefficiencies in the investment process (IMF (2015b)). Improving institutional arrangements for allocating public investment projects is critical for enhancing efficiency.
- Quasi-fiscal activities: the potential for efficiency improvements extends to reform of inefficient SOEs and privatizations, which can provide significant savings.

### Energy subsidies and taxation
- Generalized energy subsidies distort consumption and production decisions and constitute a poor instrument for income redistribution (Arze del Granado et al. (2012)).
- 2015 estimate: spending on energy subsidies (on a post-tax basis) was estimated at US$5.3 trillion (or 6½ percent of global GDP).
- Carbon or congestion taxes could potentially generate significant revenue gains, "as much as 2.9 percent of global GDP" based on Gupta and Keen (2015).
- Countries could also raise revenues by focusing on broadening tax bases.

### Conceptualization and challenges of fiscal space
- Fiscal space is challenging to operationalize; various empirical strategies exist (Box 2).
- Common practical formulations:
  - Debt sustainability: difference between current public debt and a specified threshold, determined by future fiscal balance adjustments, vulnerability to shocks (proxied by income levels), and realism of needed adjustments based on track record.
  - Financing scope: ability to finance deficits without a sharp spike in funding costs or excessive crowding-out of private investment.
- Fiscal space cannot be pinned down purely mechanically; judgment is required based on a variety of metrics as debt sustainability thresholds, likely shocks, and economic institutions differ across countries.4

### Existing IMF analytical approaches and indicators
- Core framework: debt sustainability analyses (DSA toolkit) as represented in IMF (2013).
- Additional long-used indicators and approaches:
  - FAD approaches summarized in a Fiscal Sustainability Risk Map across six dimensions (three baseline dimensions: short and medium-term fiscal fundamentals, long-term fiscal challenges, asset and liability management; three shock-related dimensions: macroeconomic developments, financial sector problems, policy implementation shortfalls).5
  - Models and indicators in the internal Vulnerability Exercise (VE) and the Fiscal Monitor, including cyclically-adjusted primary balance, the interest rate-growth differential, gross financing needs (GFN), and long-term age-related spending.6
  - Recent proposals in IMF (2016) for a comprehensive fiscal stress test and probabilistic tools to map uncertainty around medium-term public debt trajectories.7
  - Use of scenario analysis and general equilibrium modeling in teams and the WEO to evaluate fiscal policy choices and implications for sustainability.8

### Box 2 — Approaches to measuring fiscal space (summary)
- Fiscal gap approach: difference between current fiscal balance and constant balance that stabilizes debt over a medium-term horizon; forward-looking but limited feedback between fiscal policies and private behavior.
- VAR-based approach: uses VAR models to capture feedback effects between fiscal and macro variables; backward-looking and susceptible to the Lucas critique; variants used in DSA and VE frameworks and IMF (2016).
- General equilibrium models: structurally founded models calibrated to reflect interaction between fiscal policy and the economy (see Kumhof et al. (2010)); used extensively in surveillance.
- Fiscal reaction function approach: estimates fiscal space as the gap between current public debt and the debt limit implied by historical fiscal adjustment and market access (e.g., Ostry et al. (2010)); relies on past data and behavior.
- Intertemporal budget constraint / stationarity and co-integration tests: assesses sustainability by testing stationarity/co-integration of debt and primary deficits or government spending and revenue (e.g., Hamilton and Flavin (1986), Trehan and Walsh (1988), Wilcox (1989)).

### A common conceptual framework and four-stage approach for assessing fiscal space
- Framework focus: forward-looking perspective; behavior of macro-fiscal variables over time and under scenarios; includes dynamic and stochastic elements. Core aspects to consider:
  - (i) state of the economy (e.g., large negative demand shocks can reduce fiscal space by undermining growth);
  - (ii) availability of financing on favorable terms and risk of sharply increasing funding costs;
  - (iii) sustainability of level and trajectory of public debt and deficits over the medium term;
  - (iv) needed adjustment to stabilize debt or achieve prudent debt ratios over the medium and long term (including expected increases in health and pension spending);
  - (v) sensitivity of fiscal sustainability to reasonable stress scenarios.
- The four-stage sequential approach (a pilot’s check-list) for bilateral surveillance assessments:
  - Stage 1. Setting the stage: consider macroeconomic setting and structural gaps, likely size of fiscal multipliers and risk premia, output gap, uncertainty of growth outlook, recent revisions to potential growth, trade and financial openness, external balance, other policy settings (e.g., monetary policy rates near the effective lower bound9), and indicators of fiscal policy credibility and implementation capacity.
  - Stage 2. Measures of fiscal sustainability under baseline policies and standardized stress tests: availability of financing, debt burden (level and trajectory of public debt and GFN), comparison to DSA indicative benchmarks, probability of exceeding debt benchmarks using fan chart technology (IMF (2016)), and size of fiscal adjustment required to stabilize debt including long-term pressures.
  - Stage 3. Simulating discretionary fiscal policy experiments relative to the baseline: use general equilibrium frameworks where possible, complemented by DSA and scenario analysis (including downside scenarios), to map macro and fiscal implications (debt, GFN), and examine debt-growth trade-offs of discretionary policies and the marginal cost of financing new spending.
  - Stage 4. Staff judgment: synthesize signals from the first three stages and country-specific factors (including rule-based fiscal frameworks and their compliance/adequacy) to arrive at the final assessment of the degree of fiscal space.
- Stage 1 sub-layers:
  - Macroeconomic conjuncture: output gap, uncertainty about growth prospects, recent revisions to potential growth, trade and financial openness, external balance, other policy settings.
  - Structural gaps: infrastructure, structural reforms, balance sheet repair and their effects on discretionary policy impacts.
  - Public investment efficiency: government capacity to efficiently enact temporary fiscal stimulus and availability of good quality and shovel-ready projects (IMF (2015b)).
- Stage 2 sub-layers:
  - Financing availability: market perceptions and funding-cost risks, debt profile (maturity, currency composition, investor base), size of liquid public financial assets.
  - Debt burden evolution: level and trajectory of public debt and GFN, comparison to DSA benchmarks, use of fan chart probability analysis.
  - Fiscal adjustment size: realism of cyclically-adjusted primary balance adjustments to stabilize debt in baseline, and longer-term adjustment needs given demographic pressures (e.g., expected increases in health and pension spending).
- Stage 3 modeling guidance:
  - Use a general equilibrium modeling approach, where feasible, to assess impacts of active fiscal scenarios on growth, inflation, debt, interest rates and other macro variables; sensitivity to behavior of risk premia and external position.14
  - Apply the same active fiscal scenarios in the DSA, informed by general equilibrium or alternative macro frameworks; DSA use allows standard stress tests and, for market-access countries, analysis of financing needs not typically examined in Fund DSGE models.13

*Box 1. Budget Neutral Growth-Friendly Fiscal Reforms (concluded).*

### 15.      In the current conjuncture, consideration of such scenarios should shed light on the

### ASSESSING FISCAL SPACE: AN INITIAL CONSISTENT SET OF CONSIDERATIONS

### Debt-growth trade-offs and scenario considerations
- Focus areas when evaluating discretionary fiscal policy:
  - Extent of slack in the economy and spending needs (and hence likely multipliers).
  - Marginal cost of financing new spending.
  - Extent to which other macro policy instruments, including monetary policy and exchange rate adjustment, may be constrained.
- Counterfactuals must be included, notably the risk that lack of fiscal action could leave the economy vulnerable to a downturn, producing worse fiscal outcomes via weaker growth and materialization of contingent liabilities.
- The fiscal sustainability–growth tradeoff is likely more favorable in countries with:
  - Larger output gaps.
  - More efficient public spending.
  - Lower funding costs.

### Stage 4: Staff judgment and contextual factors
- Final assessment of fiscal space is based on Stages 1–3 plus country-specific considerations and inter alia the following:
  - Fiscal frameworks:
    - Fiscal rules support credibility and market access and thus fiscal space.
    - Well-designed rules support explicit medium-term objectives while leaving flexibility in shocks or exceptional circumstances.
    - Some risks (e.g., protracted demand shortfalls and deflationary pressures) are hard to operationalize ex ante in rules.
    - Tradeoff: greater fiscal flexibility versus risk of losing credibility by deviating from medium-term commitments.
    - Recommendation: staff should regularly conduct Stages 1–3 analyses, compare results to fiscal framework requirements, highlight tradeoffs, and evaluate the appropriateness of the framework where significant discrepancies persist; consider reforms and assess scope for strengthening rule design and effectiveness under alternative scenarios.
  - Currency unions:
    - Lack of independent monetary policy can complicate maintaining appropriate policy mix.
    - Temporary deviations from fiscal rules are more complicated and require multilateral negotiations.
    - Greater intra-union spillovers complicate assessment of fiscal multipliers, as spillovers to other members may need internalization.
  - Uncertainty about indicator results:
    - Modeling uncertainty arises from assumptions about historic shocks, multipliers, risk premium, contingent liabilities, structural breaks, and potential market-reaction thresholds.
    - These uncertainties affect fiscal sustainability and fiscal space assessments.

### Conclusions and recommended policy orientation
- The note presents a consistent, four-step approach to fiscal space assessment:
  1. Situate the country in terms of initial conditions (cyclical position and structural gaps) to inform potential fiscal multipliers and risk premia.
  2. Assess indicators of fiscal sustainability related to market access, level of debt, and gross financing needs under staff baseline and stress tests.
  3. Simulate effects of discretionary fiscal policies and alternative scenarios on fiscal sustainability, growth, inflation, and other macro variables.
  4. Use these inputs to inform staff assessments of fiscal space, incorporating country-specific factors not captured by generic criteria.
- With adjustments, the framework could apply to the entire Fund membership; logic remains relevant despite data limitations in low-income countries and economies without market access.
- Regardless of fiscal space views, countries should aim for growth-friendly tax and expenditure policies. Options include:
  - (i) Strengthening incentives for work and investment in human capital through reform of labor taxes and social benefits (reducing “tax wedges”).
  - (ii) Encouraging private investments and R&D by reforming corporate income taxes and well-targeted tax incentives.
  - (iii) Raising productive capacity through efficient public investment, especially in infrastructure.
  - (iv) Promoting human capital accumulation through broad access to education and health care.

### Issues for further work
- Definition of benchmarks:
  - Appropriate benchmarks for fiscal indicators remain debated, including for advanced economies and reserve currency issuers.
  - Initial approach: relate thresholds to likelihood of fiscal stress (e.g., Baldacci et al. (2011)); DSA and VE thresholds use a “signaling” approach to identify indicator levels that best predicted fiscal stress in the past.
- Behavior of risk premium:
  - Risk premia can move sharply and non-linearly under tightening global liquidity, heightened risk aversion, worsening macro fiscal indicators, discretionary fiscal policies, or repeated breach of fiscal rules.
  - Stage 3 can examine alternative scenarios with different risk premia based on country historical experience; more systematic modeling of risk premia behavior is needed.
- Design of fiscal rules:
  - Fiscal rules typically evolve; FAD plans cross-country analytical work on desirable features of fiscal rules based on historical experience.
- The framework will be updated based on implementation experience and new metrics developed by Fund staff.

### Annex I — Selected indicators (summary of potential indicators)
- Stage 1 potential indicators:
  - EBA Current Account Gap: deviation of observed current account from EBA norm; positive value suggests stronger than desirable current account.
  - EBA Domestic Fiscal Policy Gap: deviation of cyclically-adjusted fiscal balance from desirable level under EBA; positive value suggests tighter than desirable fiscal stance.
  - Structural Reform Related Gaps: third-party indicators (e.g., World Bank Doing Business, OECD indices) may be considered.
  - Real public capital stock per capita: constructed via perpetual inventory; series expressed in constant international 2005 prices (PPP).
  - Efficiency of public investment: PIMA score ranges between 0 and 10 based on up to 45 key design features assessed across 15 PIM institutions.
- Stage 2 potential indicators:
  - Financing and debt burden indicators: MAC DSA framework calibration uses the signal approach separately for EMs and AEs.
  - Definition of debt distress events:
    - For EMs: Default; Restructuring and rescheduling; MF financing.
    - For AEs: Default (S&P definition); Restructuring and rescheduling; IMF financing in excess of 100 percent of quota; Inflation greater than 35 percent per annum; Sovereign spreads greater than 1000 basis points or 2 standard deviations from the country average.
  - Signal-approach benchmarks:
    - Benchmarks derived by minimizing missed crises and false alarms; medians computed separately for AEs and EMs.
    - A noise-to-signal ratio below 100 suggests the indicator is an efficient predictor.
    - Debt level benchmark increased by about 20 percent for higher scrutiny group: to 70 for EMs and 85 for AEs.
  - Risk assessment benchmarks for debt profile indicators:
    - Early warning benchmarks are scaled down and derived by minimizing type I and type II errors relative to VEE and VEA results; separate early warning benchmarks for EMs and AEs were calculated.
  - Probability of Breaching Debt Benchmark:
    - Calculated using simulated distributions of future debt outcomes via stochastic simulations of macroeconomic and fiscal shocks; yields probabilities that public debt exceeds a threshold over projection period.
  - Realism of Adjustment Required to Stabilize Debt:
    - Cross-country guidance: closer scrutiny required if (i) planned cyclically-adjusted primary fiscal adjustment over any three years during projection horizon is larger than 3 percent of GDP; or (ii) average of cyclically adjusted primary balance for any consecutive 3-year period during projection horizon is greater than 3.5 percent of GDP.
  - Long-Term Adjustment Need:
    - Measures change in cyclically-adjusted primary balance needed between now and 2020 (and maintained until 2030) to reduce public debt to 60 and 40 percent of GDP by 2030 for advanced and emerging economies respectively while offsetting expected increases in age-related spending.
    - Net debt is used for Australia, Canada and Japan. For Japan, the net debt target is 80 percent, which corresponds to a gross debt of 200 percent.

*Source: ASSESSING FISCAL SPACE: AN INITIAL CONSISTENT SET OF CONSIDERATIONS (excerpts).*

### References

### ASSESSING FISCAL SPACE: AN INITIAL CONSISTENT SET OF CONSIDERATIONS

### Fiscal sustainability, public debt, and sovereign risk
- Blanchard, O., J.C. Chouraqui, P.R. Hagemann, and N. Sartor, 1990, “The Sustainability of Fiscal Policy: New Answers to an Old Question,” OECD Economic Studies, vol. 15, pp. 7–36.
- Buiter, W., 1985, “A Guide to Public Sector Debt and Deficit,” Economic Policy, vol. 1, no. 1, pp. 13–79.
- Buiter, W., G. Corsetti, and N. Roubini, 1993, “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht,” Economic Policy, vol. 16, pp. 57–100.
- Cecchetti, S. G., M.S. Mohanty, and F. Zampolli, 2011, “The Real Effects of Debt,” Federal Reserve Bank of Kansas City, Economic Symposium 2011: Achieving Maximum Long-Run Growth, pp. 145–96.
- Hamilton, J., and M. Flavin, 1986, “On the Limitations of Government Borrowing: A Framework for Empirical Testing,” American Economic Review, vol. 76, pp. 808–19.
- Hakkio, C., and M. Rush, 1991, “Is the Budget Deficit Too Large?” Economic Inquiry, vol. 29, pp. 429–45.
- Kumar, M., and J. Woo, 2010, “Public Debt and Growth,” IMF Working Paper 10/174 (Washington: International Monetary Fund).
- Pescatori, A., D. Sandri, and J. Simon, 2014, “Debt and Growth: Is There a Magic Threshold?” IMF Working Paper 12/11 (Washington: International Monetary Fund).
- Trehan, B., and C. Walsh, 1988, “Common Trends, the Government Budget Constraint, and Revenue Smoothing,” Journal of Economic Dynamics and Control, Vol. 12, pp. 425–44.
- Uctum, M., and M. Wickens, 2000, “Debt and Deficit Ceilings, and Sustainability of Fiscal Policies: An Intertemporal Analysis,” Oxford Bulletin of Economics and Statistics, vol. 62, pp. 197–222.
- Wilcox, D., 1989, “The Sustainability of Government Deficit: Implications of the Present Value Constraint,” Journal of Money, Credit and Banking, vol. 21, pp. 291–306.
- Debrun, X., and T. Kinda, 2013, “That Squeezing Feeling: The Interest Burden and Public Debt Stabilization,” IMF Working Paper 12/125 (Washington: International Monetary Fund).
- Schaechter, A., and others, 2012, “A Toolkit to Assessing Fiscal Vulnerabilities and Risks in Advanced Economies,” IMF Working Paper 12/11 (Washington: International Monetary Fund).
- Cottarelli, C., 2011, ““The Risk Octagon: A Comprehensive Framework for Assessing Sovereign Risks,” presented in University of Rome “La Sapienza,” January. Available via the Internet: www.imf.org/external/np/fad/news/2011/docs/Cottarelli1.pdf

### Fiscal policy, growth, multipliers, and macroeconomic effects
- Blanchard, O., and D. Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper 13/1 (Washington: International Monetary Fund).
- Easterly, W. and S. Rebelo, 1993, “Fiscal Policy and Economic Growth,“ Journal of Monetary Economics 32, pp. 417-458.
- Baldwin, E., B. Clements, S. Gupta, and Q. Cui, 2008, "Social Spending, Human Capital, and Growth in Developing Countries," World Development, Elsevier, vol. 36(8), pp. 1317-1341, August.
- Everaert, G., F. Heylen, and R. Schoonackers, 2014, “Fiscal Policy and TFP: Measuring Direct and Indirect Effects,” Working Paper Research 274, National Bank of Belgium.
- Mertens, K. and Ravn, M. (2014), ‘Fiscal Policy in an Expectations-Driven Liquidity Trap’, Review of Economic Studies, vol. 81, pp. 1637-67.
- Correia, I., E. Farhi, J.P. Nicolini, and P. Teles, 2013, “Unconventional Fiscal Policy at the Zero Bound,” American Economic Review, vol. 103, pp. 1172-1211.
- Chung, H., and E. Leeper, 2007, “What Has Financed Government Debt?” NBER Working Paper No. 13425 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Ghosh, A., J. Kim, E. Mendoza, J. Ostry, and M. Qureshi, 2013, “Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies,” Economic Journal, vol. 123, pp. F4–30.
- Baum, A., C. Checherita, and P. Rother, 2013, “Debt and Growth: New Evidence from the Euro Area,” Journal of International Money and Finance, vol. 32, pp. 809–21.
- Giannitsarou, C., and A. Scott, 2006, “Inflation Implications of Rising Government Debt,” in NBER International Macro Annual, ed. by L. Reichlin and K. West (Cambridge, Massachusetts: MIT Press).
- Blanchard, O. and C. Cottarelli, 2010, “Ten Commandments for Fiscal Adjustment in Advanced Economies,” IMFdirect, June 24.
- Kumhof, M., D. Laxton, D. Muir, and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF): Theoretical Structure,” IMF Working Paper 10/34 (Washington: International Monetary Fund).

### Public investment, public capital, and efficiency of spending
- Bom, P. and J. Ligthart, 2010, “What Have We Learned from Three Decade of Research on the Productivity of Public Capital?,” CESifo Working Paper Series No,. 2206, Center Discussion Paper No. 2008-10.
- Munnell, A., 1992, “Policy Watch, Infrastructure Investment and Economic Growth, “ Journal of Economic Perspectives, Vol. 6, No. 4, pp. 189-198.
- Romp, W. and J. de Haan, 2005, "Public Capital and Economic Growth: A Critical Survey," EIB Papers 2/2005, European Investment Bank, Economics Department.
- Gupta, S., A. Kangur, C. Papageorgiou, and A. Wane, 2014, "Efficiency-Adjusted Public Capital and Growth," World Development, Elsevier, vol. 57(C), pp. 164-178.
- Grigoli, F. and J. Kapsoli, 2013, "Waste Not, Want Not; The Efficiency of Health Expenditure in Emerging and Developing Economies," IMF Working Papers 13/187 (Washington: International Monetary Fund).
- International Monetary Fund, 2015b, “Making Public Investment More Efficient,” IMF Policy Paper (Washington).
- International Monetary Fund, 2014a, “Is it Time for an Infrastructure Push? The Macroeconomic Effects of Public Investment,” in IMF October World Economic Outlook (Washington).

### Revenue, subsidies, and expenditure composition
- Arze del Granado, Francisco Javier, D. Coady, and R. Gillingham, 2012, "The Unequal Benefits of Fuel Subsidies: A Review of Evidence for Developing Countries," World Development, Elsevier, vol. 40(11), pp. 2234-2248.
- Gupta, S. and M. Keen, 2015, “Global Energy Subsidies Are Big―About $5 Trillion Big,” IMFdirect, May 18.
- International Monetary Fund, 2015e, “Current Challenges in Revenue Mobilization: Improving Tax Compliance” (Washington).
- Phillips, S., L. Catao, L. Ricci, R. Bems. M. Das, J. Di Giovanni, D. Filiz Unsal, M. Castillo, J. Lee, J. Rodriguez, and M. Vargas, 2013, “The External Balance Assessment (EBA) Methodology,” IMF Working Paper 13/272 (Washington: International Monetary Fund).
- Dhont, T. and F. Heylen, 2009, “Employment and Growth in Europe and the US: The Role of Fiscal Policy Composition,“ Oxford Economic Papers, Vol. 61, pp. 538-565.

### Analytical toolkits, indicators, and early warning
- Kaminsky, G., S. Lizondo, and C. Reinhart, 1998, “Leading Indicators of Currency Crisis,” IMF Staff Papers, vol. 54, no. 1, pp. 1-48 (Washington).
- Heller, P., 2005, “Understanding Fiscal Space,” IMF Policy Discussion Paper 05/4 (Washington: International Monetary Fund).
- Ostry, J., A. Ghosh, J. Kim, and M. Qureshi, 2010, “Fiscal Space,” IMF Staff Position Note 10/11 (Washington: International Monetary Fund).
- Polito, V., and M. Wickens, 2005, “Measuring Fiscal Sustainability,” CEPR Discussion Paper No. 5315 (Washington: Center for Economic and Policy Research).
- Polito, V., and M. Wickens, 2011, “Assessing the Fiscal Stance in the European Union and the United States, 1970–2011,” Economic Policy, vol. 26, no. 68, pp. 599–647.
- Schaechter, A., and others, 2012, “A Toolkit to Assessing Fiscal Vulnerabilities and Risks in Advanced Economies,” IMF Working Paper 12/11 (Washington: International Monetary Fund).
- International Monetary Fund, 2010, “The IMF-FSB Early Warning Exercise: Design and Methodological Toolkit,” IMF Policy Paper (Washington).

### Health, social spending, and sectoral efficiency
- Baldacci, E., B. Clements, S. Gupta, and Q. Cui, 2008, "Social Spending, Human Capital, and Growth in Developing Countries," World Development, Elsevier, vol. 36(8), pp. 1317-1341, August.
- World Health Organization, 2010, "Improving Health System Efficiency as a Means of Moving Towards Universal Coverage," World Health Report.
- Grigoli, F. and J. Kapsoli, 2013, "Waste Not, Want Not; The Efficiency of Health Expenditure in Emerging and Developing Economies," IMF Working Papers 13/187 (Washington: International Monetary Fund).

### Other methodological and theoretical contributions
- Heller, P., 2005, “Understanding Fiscal Space,” IMF Policy Discussion Paper 05/4 (Washington: International Monetary Fund).
- Polito, V., and M. Wickens, 2005, “Measuring Fiscal Sustainability,” CEPR Discussion Paper No. 5315 (Washington: Center for Economic and Policy Research).
- Giannitsarou, C., and A. Scott, 2006, “Inflation Implications of Rising Government Debt,” in NBER International Macro Annual, ed. by L. Reichlin and K. West (Cambridge, Massachusetts: MIT Press).
- Trehan, B., and C. Walsh, 1988, “Common Trends, the Government Budget Constraint, and Revenue Smoothing,” Journal of Economic Dynamics and Control, Vol. 12, pp. 425–44.

*References section from "ASSESSING FISCAL SPACE: AN INITIAL CONSISTENT SET OF CONSIDERATIONS."*

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_Source: https://www.imf.org/-/media/files/publications/pp/pp5080-assessing-fiscal-space-an-initial-consistent-set-of-considerations.pdf_