## _111607a — Executive Summary and Key Findings

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### Executive Summary — Main conclusions
- Globalization and financial deepening can raise economic growth and improve overall fiscal positions, but can also put pressure on government finances.
- Revenue generally robust but could decline if tax competition intensifies; strengthening tax administration and promoting cooperation to avoid harmful tax practices will gain importance.
- Upward expenditure pressure may arise from increased demand for social protection and infrastructure investment.
- Contingent fiscal liabilities in the financial sector could increase.
- If fiscal pressures materialize, fiscal policy should be prepositioned to respond by adjusting revenue and expenditure or having the capacity to borrow; strengthens case for early fiscal adjustment where debt sustainability concerns exist.
- Prepositioning and fiscal adjustment should account for likely deterioration in fiscal positions due to population aging and climate change (Section II).
- Reaping benefits requires commitment to fiscal discipline: financial globalization could enhance market discipline but also facilitate excessive borrowing where fiscal frameworks are weak.
- Sound fiscal policies and institutions, careful fiscal monitoring, and timely responses will help sustain trends in “redemption from original sin” and “increased debt tolerance” (Section III).
- Fiscal policy can, in some situations, respond to adverse macroeconomic consequences of large capital inflows; if inflows create or reflect aggregate demand pressure, fiscal stabilization may be appropriate and effective (country specific) (Section IV).
- Globalization amplifies fiscal policy spillovers, strengthening the case for enhanced policy cooperation, particularly for common shocks such as population aging (Section V).
- Paper surveys analytical and empirical work, draws policy implications, and outlines a work agenda (Section VI).

*Key cross-cutting messages*
- Focus on macrofiscal aspects of globalization and financial deepening; many related fiscal-dimension topics (distributional, labor market, trade consequences, structural fiscal issues, fiscal–financial market interactions, pensions) are not covered.
- Sections II and V more applicable to industrial countries; Sections III and IV apply more to emerging market countries (and to some extent to developing countries).

### Analytical approach
- Stock-taking of known and unknown; where literature is inconclusive or theoretical outcome unclear, identifies needs for further analysis.
- Emphasizes country-specific assessment and role of institutions and fiscal frameworks.

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### II.A Tax revenue: findings and evidence
- Concern: globalization could increase tax competition and reduce ability to tax mobile factors, especially corporate taxation.
- Observed trend in corporate taxation:
  - Industrial countries: statutory corporate tax rates declined over past two decades from an average of around 45 percent to around 35 percent.
  - Poland: statutory corporate tax rate reduced from 38 percent in 1997 to 19 percent in 2007.
  - Czech Republic: reduced from 41 percent to 25 percent over a similar period.
  - Emerging market countries in Europe, and emerging markets in Asia and Latin America, also show recent declines in corporate tax rates.
- Despite rate declines, corporate tax revenue has held up:
  - Industrial countries experienced an increase in corporate tax revenue on average, both relative to GDP and to total tax revenue.
  - Emerging market countries: corporate tax revenue now accounts for almost 20 percent of total tax revenue—the highest ratio recorded for these countries.
- Explanations for declining rates but rising revenue:
  - Strengthened pace of economic activity and record-high profits in many countries.
  - Effective corporate tax rates have fallen much less than statutory rates.
  - Corporate tax base broadening: cutting exemptions and strengthening tax administration.
  - Other contributors: increased share of profits in GDP; increased volatility of profits with only partial loss-carryover; shift from personal to corporate taxation as lower corporate tax rates encouraged incorporation; shift from debt to equity financing (debt tax deductible while equity generally is not).
- Outlook and risks:
  - As cyclical factors abate and scope for further base broadening shrinks, additional lowering of tax rates on mobile factors could reduce tax revenue.
  - Heavier taxation of less mobile factors could exacerbate tax distortions and equity concerns.
  - Growth of electronic commerce, offshore financial centers, and new financial instruments (especially derivatives) could make monitoring activity and profits more difficult, adversely affecting tax compliance.
- Policy responses and international cooperation:
  - Cooperative approaches focus on containing harmful tax practices, not harmonizing rates or bases.
  - Cooperation may be especially significant for developing countries with limited market access that depend on protecting revenue base.
  - Net welfare effects of cooperation are unclear; some degree of tax competition can be welfare-enhancing.

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### Financial deepening and tax policy; VAT and relative taxation
- Financial deepening can reduce revenue volatility by improving private smoothing, but can also increase revenue volatility because financial sector income tends to be more volatile (example: Hong Kong).
- VAT treatment of financial services debated due to bundling of intermediation and services:
  - Most countries exempt financial services from VAT.
  - Some countries (e.g., New Zealand, Singapore) switched to zero-rating so financial institutions can claim VAT credits for inputs (Zee, 2004); revenue impact of zero-rating is unclear.
- Relative taxation of equity and debt revisited (example: Germany limiting tax deductibility of interest), with likely effects on capital structure as suggested by cross-country evidence.
- Reported indicators associated with relative taxation categories (Figure 6 averages, in percent): 142.3; 26.1; 7.5; 19.7; 77.6; 19.9; 14.2; 41.1; 72.0; 18.2; 22.9; 36.9.

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### Expenditure pressures and globalization
- Two trends likely to increase demand for public spending despite downward revenue pressure:
  - Increased inequality prompting calls for more social protection and income support/training for low-skilled workers affected by trade opening.
  - Need to invest in economic and social infrastructure to remain competitive; private sector and public-private partnerships can help, but additional public investment remains crucial. Possible expenditure competition (e.g., employment subsidies) to attract foreign investors.
- Empirical evidence mixed:
  - Trade openness may stimulate higher government spending (Rodrik, 1998).
  - Increased financial globalization (Liberati, 2006), and trade openness combined with financial globalization (Garrett and Mitchell, 2001) lead to lower government spending.
  - Findings differ by data scope (central government focus) and controls on capital flows.
- Other looming expenditure pressures:
  - Retirement of baby boom generation and rising longevity: EU25 estimates indicate average expenditure increase by 2050 likely to be around 3½ to 4 percent of GDP (Economic Policy Committee of the European Union, 2006).
  - Climate change adaptation and mitigation: annualized cost of greenhouse gas mitigation consistent with stabilizing the stock of greenhouse gases estimated at 1 percent of global GDP (IMF, 2007a).

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### Contingent liabilities from the financial sector
- Financial sector is common source of government contingent liabilities, primarily from bailouts to avoid contagion and protect depositors.
- Typical assistance sequence: containment (deposit guarantees, low-cost credit) followed by restructuring (write-offs, recapitalization).
- Fiscal costs of containment and restructuring have often been large.
- Financial crises tend to follow periods of rapid financial liberalization and innovation due to excessive credit growth and deteriorating lending standards, especially when combined with large capital inflows:
  - Empirical example: 18 out of 26 banking crises in industrial and developing countries during the 1980s and 1990s occurred within five years of substantial financial liberalization (Kaminsky and Reinhart, 1999).
- Globalization and financial deepening raise short-run financial risks (rapid market expansion, new instruments, increased global liquidity, higher risk appetite). A rise in risk aversion could cause large corrections, especially in credit derivatives.
- Recent market developments (sub-prime repricing) had global repercussions, including bailouts and nationalizations (examples referenced).
- In some large emerging markets, financial sector contingent liabilities under severe stress scenarios are estimated in the range of 30–40 percent of GDP.
- Reference: Standard and Poor’s (2007) “bottom-up” stress-testing estimates.

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### Responding to fiscal pressure: prepositioning and adjustment
- Fiscal policy should be prepositioned to retain maneuvering room rather than assume adverse outcomes will materialize.
- Key elements of prepositioning:
  - Develop capacity to increase revenue, reduce expenditure, and/or borrow more should fiscal pressures emerge.
  - Undertake early fiscal adjustment in countries facing actual or potential debt sustainability difficulties.
  - Avoid procyclical fiscal responses, especially during good times.
- Aim: ensure pressures from globalization do not create debt sustainability concerns or necessitate harmful ad hoc fiscal adjustment.

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### Consequences for fiscal discipline — Market discipline and evidence
- Markets exercise fiscal discipline mainly through impact of fiscal deficits on credit risk premium.
  - For highly rated countries, the actual credit risk premium tends to respond by around 5 basis points to each 1 percentage point change in deficit or debt ratio.
  - In emerging market countries, a one percentage point of GDP increase in the deficit has been found to raise foreign and domestic currency interest rate spreads by about 20 and 30 basis points respectively; stronger response if deficit increases are due to higher government consumption.
- Market reactions often non-linear: modest over a range but strong once deficits/debt exceed thresholds.
- Financial globalization could strengthen market discipline if international investors monitor fiscal policies more closely; external developments (reduced investor risk appetite) can also trigger sharp market responses.
- Financial globalization could weaken fiscal discipline in short term by dampening visible cost of government borrowing (more ready access to external financing), tempting governments to postpone adjustment.
- Empirical evidence inconclusive:
  - Kim (2003): capital account liberalization associated with lower fiscal deficits.
  - Tytell and Wei (2004): de facto financial globalization appears to have no significant impact on fiscal deficits.
  - Abiad and others (2008): financial globalization enhances fiscal discipline in countries with good institutions, but in absence of such institutions and with low initial government debt leads to weaker discipline.
- Recommended dual approach:
  - Strengthen market discipline (greater market openness, reduction in domestic captive financing, increased transparency about government borrowing and public debt).
  - Strengthen fiscal policies and institutions to reinforce market discipline.

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### Redemption from original sin — trends, benefits, caveats
- Original sin: difficulty for developing countries to borrow externally in their own currency, exposing public debt to currency risk.
- Currency depreciations have caused significant jumps in public debt-to-GDP ratios in several crisis countries.
- Starting with Colombia in 2004, other emerging markets (Brazil, Mexico, Uruguay) issued local currency external debt—reflects redemption from original sin.
- Indicators of redemption:
  - Falling ratio of external to total public debt across emerging countries.
  - Rising share of domestic debt held by nonresidents in a number of countries (examples: Kenya, Korea, Brazil, Malaysia, Mexico, Indonesia, Zambia, Poland, Hungary showed increases between June 2002 and June 2006 in source charts).
- Improvement in domestic debt issuance:
  - New domestic currency debt increasingly issued with fixed coupons and long maturities (examples: Mexico issued a fixed coupon 30-year bond; Brazil, Colombia, Indonesia, Russia issued 10-year or longer fixed coupon bonds).
  - A standardized measure of domestic original sin fell significantly between 1998 and 2004 in most emerging market countries.
- Table 1 excerpt — Long-term fixed-rate domestic debt / Total domestic debt (selected markets, values):
  - Brazil 1.00 1.00 0.98
  - Turkey 0.89 0.90 0.66
  - Mexico 1.00 0.85 0.61
  - Colombia ... 0.67 0.56
  - Indonesia 0.80 0.56 0.50
  - Bulgaria 0.84 0.49 0.35
  - Hungary 0.64 0.51 0.33
  - Egypt 0.52 0.24 0.29
  - Czech Republic 0.59 0.56 0.22
  - India 0.05 0.05 0.07
  - Russia 0.07 0.13 0.03
- Note: Domestic original sin measured as 1 – (Long-term fixed-rate domestic debt / Total domestic debt).
- Benefits of redemption:
  - Larger share of debt in domestic currency and more flexible maturities reduce balance sheet vulnerability.
  - Opportunities to lower government financing costs; potential contributions to financial development, risk-sharing, and growth.
- Caveats and risks:
  - Must balance local and foreign currency debt to avoid temptation to inflate local currency debt and avoid harming banking sector development (Hauner, 2008).
  - Spreads on foreign currency debt remain useful measures of country risk and benchmarks for corporate bonds.
  - Redemption may increase exchange rate volatility because foreigners trade more actively.
  - Uncertainty whether redemption is permanent; original sin might reassert during periods of limited global liquidity and risk appetite.
  - Policy recommendation: bolster credibility through commitment to fiscal discipline to help make redemption permanent.

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### Growth, financial development, and debt tolerance
- Positive relationship between financial development and economic growth (Levine, 1997); some heightened short-term crisis risk.
- Positive relationship between trade openness and growth (Lopez, 2005); causality often from openness to growth.
- Financial globalization and growth: mixed evidence:
  - FDI and non-debt creating inflows positively associated with longer-term growth.
  - Impact of debt-creating inflows depends on strength of policies and institutions.
  - Identification complications: capital account liberalization may raise short-term interest rates; crises probabilities may obscure long-term benefits (Rancière, Tornell and Westermann, 2006).
- Financial globalization and macroeconomic volatility: ambiguous; empirical evidence suggests no significant impact overall (IMF, 2007c), particularly for countries with well-developed financial markets and institutions.
- Implications for debt tolerance:
  - Globalization and financial deepening that increase growth and lower volatility increase debt tolerance.
  - Benefits more likely for countries with well-developed financial systems and institutions pursuing sound policies.
  - Policy recommendation: governments should credibly commit to fiscal discipline.

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### Role of fiscal policy: stabilization, multipliers, and capital flows
- Fiscal policy roles: resource allocation, redistribution, stabilization amid increased capital flows.
- Globalization and financial deepening can make fiscal multipliers larger or smaller:
  - Crowding out via interest rate channel reduced as capital mobility increases.
  - Under fixed exchange rates with high capital mobility, fiscal policy becomes more effective; under flexible rates, exchange rate movements can offset fiscal demand impacts, weakening effectiveness.
  - Credibility effects influence multipliers via private expectations; effects depend on initial debt stock and financing composition.
- Trade openness likely reduces fiscal multipliers modestly via import leakage; evidence limited.
- Financial deepening enables countercyclical fiscal policy by deepening markets and lessening crowding out, but countervailing effects (removed captive financing, Ricardian-like private smoothing) can offset.
- Empirical indication: Figure 11 relates fiscal policy procyclicality to private sector credit-to-GDP ratio (N= 85).
- Financial globalization similarly dampens domestic interest rate sensitivity to deficits, potentially increasing multipliers; economic size matters.
  - Evidence: access to larger pool of foreign savings reduced impact of deficits on interest rates for large industrial countries (Hauner and Kumar, 2006; European Central Bank, 2006).
  - Aisen and Hauner (2008): effect of deficits on interest rates smaller for financially more open economies.
- Fiscal policy response to capital flows:
  - Appropriateness of fiscal tightening/loosening depends on causes and consequences of flows, exchange rate regime, size and openness of economy, and initial fiscal position.
  - Fiscal tightening often appropriate when inflows are supply-determined and temporary (changes in liquidity, investor risk appetite).
    - Tightening can relieve demand pressure and lower domestic interest rates, especially with monetary easing.
    - Tightening may be appropriate if inflows finance a large current account deficit.
  - Cases where tightening may be inappropriate:
    - Large current account surplus (tightening could exacerbate imbalances).
    - Tightening that improves credibility could attract more inflows (counterproductive).
    - Countries with already large primary surpluses (e.g., Estonia and Turkey) may find further tightening difficult.
    - For structurally higher inflows reflecting real investment opportunities, appreciation may be preferred; fiscal tightening can still slow appreciation and avoid overheating.
  - Other options: sterilized exchange intervention and capital flow controls (with limitations).
  - Implementation lags: fiscal policy may be slow; automatic stabilizers help, but discretionary measures may be needed for equity concerns.
- Empirical correlations:
  - Central and Eastern Europe: lower fiscal deficits tend to be associated with higher net capital inflows (Figure 12, upper chart).
  - Lower fiscal deficits associated with less real exchange rate appreciation in Central and Eastern Europe (Figure 12, lower chart), despite larger capital inflows.
  - Broader-sample evidence: countries responding to inflows with fiscal tightening experienced smaller exchange rate appreciation than those that intervened in foreign exchange or tightened controls (IMF, 2007a).

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### Box 1 — Selected fiscal policy responses to capital inflows: historical episodes and outcomes
- Episodes where fiscal tightening and other responses occurred:
  - Indonesia: 1990–94 (Accelerated debt repayment, 1994)
  - Korea: 1992–94
  - Malaysia: 1988–94
  - Philippines: 1990–95 (Accelerated debt repayment, 1994–95)
  - Thailand: 1988–91 (Accelerated debt repayment, 1988–90)
  - Argentina: 1991–93
  - Chile: 1989–95
  - Mexico: 1989–93
  - Czech Rep.: 1996–97
- Regional patterns:
  - Central and Eastern Europe (EU accession inflows): most did not tighten fiscal policy; exceptions Baltic countries—allowed currency appreciation.
  - Asia: fiscal tightening played a relatively small role; automatic stabilizers allowed in some countries; focus on exchange rate flexibility and appreciation.
  - Estonia: currency board pressured; general government balance already in surplus; considered shifting public expenditure away from nontraded sector.
  - Turkey: large inflows under floating currency caused appreciation; high primary fiscal surplus limited scope for further tightening.
- Composition and tax-policy implications:
  - Well-targeted spending cuts can increase expenditure efficiency and create room to reduce taxes with supply-side benefits.
  - Taxation of nontraded goods (e.g., real estate) raises revenue when inflows shift resources into nontradables.
  - Tax measures can help limit asset-price bubbles (example: China introduced capital gains tax and VAT on land).
- Empirical evidence on expenditure restraint (Table 2: Change in Net Capital Inflow; Real Exchange Rate Appreciation; Deviation of Government Expenditure-to-GDP Ratio):
  - Malaysia, 1989–96 — 5.7; 6.9; -2.3
  - Thailand, 1987–95 — 9.1; 5.5; -1.6
  - Chile, 1989–97 — 5.6; 18.6; -1.3
  - Indonesia, 1990–96 — 1.6; 8.1; -1.0
  - Singapore, 1987–92 — 7.1; 2.3; -0.9
  - Korea, 1990–96 — 5.5; 7.4; 0.2
  - China, 1993–96 — 5.0; -6.8; 0.4
  - Brazil, 1992–96 — 3.9; 14.7; 0.8
  - Peru, 1992–97 — 9.0; 19.7; 1.5
  - Philippines, 1989–96 — 4.8; 11.2; 1.9
  - Mexico, 1989–93 — 6.9; 33.8; 1.9
  - Colombia, 1992–96 — 3.9; 18.1; 2.3
  - Argentina, 1990–93 — 8.8; 43.5; 2.6
- Simulations (GIMF) of a permanent U.S. fiscal consolidation that permanently reduces U.S. public debt-to-GDP ratio by 15 percentage points and raises long-term overall budget balance by 0.5 percent of GDP:
  - Limited financial integration:
    - U.S. current account improves by 0.1 percent of GDP.
    - Domestic real interest rates decline six times more than world interest rates.
    - Permanent output gain of 5 percent (concentrated in the United States).
  - High financial integration:
    - U.S. current account improves permanently by 0.3 percent of GDP.
    - Additional U.S. saving leaks abroad; accumulation of net foreign assets contributes to steady decline in global interest rates.
    - World interest rates remain permanently lower.
    - Crowding in shared evenly, with permanent output gain of 3 percent in both the United States and the rest of the world.
  - Conclusion: longer-term spillover effects of fiscal consolidation increase with degree of financial integration.
- Policy implications from Box 1:
  - Composition matters: well-targeted spending cuts can improve efficiency and enable tax reductions with supply-side benefits.
  - Tax structure can help absorb inflow-induced sectoral shifts (e.g., taxation of nontradables).
  - Tax measures can help limit asset-price bubbles.
  - Fiscal tightening during inflow peaks can reduce monetary policy pressure and create space to respond to subsequent reversals.

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### Tax and expenditure reform; contingent liabilities; fiscal institutions (policy recommendations)
- Tax and expenditure reform:
  - Room may exist to expand tax bases and strengthen administration, but limited scope for additional taxation of immobile factors for efficiency and equity reasons.
  - Administrative difficulties especially for developing countries shifting from “easy to collect” taxes (tariffs) to “hard to collect” income taxes and VAT.
  - Action on expenditure side most likely and desirable; link between high-quality spending cuts and successful fiscal adjustment is well-established.
  - Recommend public expenditure review to identify scope to reduce spending and alter its mix; specifically assess appropriate size and structure of social protection in a more open economy and measures to mitigate poverty and social impacts of globalization.
- Financial sector contingent liabilities (section 56):
  - Contingent liabilities can create solvency and liquidity problems.
  - Recommendations:
    - Identify, quantify, and disclose explicit contingent liabilities and formally incorporate them into debt sustainability analysis.
    - Increase awareness of implicit contingent liabilities (stand-behind obligations).
    - Adopt timely intervention strategies emphasizing preemptive restructuring of at-risk financial institutions to reduce fiscal costs.
    - Strengthen supervision to help prevent and manage contingent liability risks.
- Fiscal policies and institutions (section 57):
  - Globalization and financial deepening can ensure redemption from original sin and possibly increase debt tolerance.
  - Recommendation: credible commitment to sound fiscal policies required to fully reap benefits.
  - Instruments to enhance credibility: fiscal rules; fiscal responsibility laws (emphasizing fiscal transparency); independent fiscal councils.
  - Emphasize ability to monitor fiscal developments and respond timely.
  - Combine measures to enhance market scrutiny with institutional reform to strengthen fiscal frameworks.
- Effectiveness of fiscal stabilization (section 58):
  - Globalization and financial deepening likely influence effectiveness of fiscal stabilization but evidence unclear.
  - Key factors: exchange rate regime; sensitivity of capital flows to interest rates; fiscal policy credibility.
  - Recommendations:
    - Avoid unnecessarily large changes in risk premia and interest rates in response to fiscal expansions and contractions.
    - Reassure financial markets about fiscal credibility to limit destabilizing market responses.
- Fiscal response to capital inflows (section 59):
  - Guidance:
    - If inflows create or reflect aggregate demand pressure, fiscal stabilization may be appropriate.
    - If inflows due to supply factors (global liquidity) or driven by current account deficit, stronger case for fiscal adjustment.
    - If inflows considered permanent, adjustment should occur mainly through real exchange rate or by loosening controls on capital outflows; fiscal policy can still ease exchange rate adjustment path.
- Policy cooperation (section 60):
  - Globalization magnifies fiscal policy spillovers, strengthening case for enhanced cooperation on common long-term challenges (population aging, climate change).
  - Some tax competition can be beneficial; cooperation may be needed to limit harmful practices.
  - Effects of tax competition differ between industrial and developing countries; developing countries often have limited recourse to alternative financing.
  - Role of the Fund:
    - Multilateral and bilateral surveillance can contribute by rigorous technical analysis of spillovers and externalities.
    - Establish common analytical framework to promote constructive dialogue.
    - Foster peer pressure and discourage deviations from mutually beneficial policies.

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### Work agenda (section 61)
- Specific work items:
  - Examine whether recent declines in corporate tax rates pose future risk to government finances; future Board paper will address tax competition issues.
  - Investigate tax policy issues from growing importance of financial sector: corporate income tax volatility; VAT treatment of financial services; relative taxation of equity and debt.
  - Identify sources of increased demand for spending to guide expenditure responses; continue work on financing infrastructure and designing well-targeted social protection.
  - Improve assessment of size of contingent liabilities and likelihood of realization to account in DSA.
  - Study whether better access to external financing strengthens or loosens fiscal discipline; investigate role of fiscal institutions, determinants of redemption from original sin and debt tolerance.
  - Clarify role of fiscal policy in responding to large capital inflows and determine appropriate policy mix; study how globalization and financial deepening affect fiscal stabilization effectiveness.
  - Analyze payoff to specific forms of policy cooperation under well-defined circumstances, including cooperation on demographic challenges and tax policies to encourage firms to reduce greenhouse gas emissions.
  - Examine potential for Fund surveillance to promote cooperation by analyzing coordination failures and fostering multilateral dialogue.
- Budgetary note: work agenda can be undertaken within current resource envelope; no direct budgetary implication.

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### VII. Issues for discussion (questions for Directors)
- Do Directors view it as likely that globalization and financial deepening will tend to reduce government revenue and increase public expenditure? If so, should cooperative policy response to limit harmful tax practices be considered, and should fiscal policy be prepositioned to help countries manage these and other fiscal pressures?
- How do Directors assess consequences of financial globalization for fiscal discipline? Is redemption from original sin temporary or permanent?
- In what circumstances do Directors view fiscal tightening as appropriate and effective response to capital inflows? Has globalization and financial deepening made fiscal stabilization more or less effective?
- How should cross-border spillovers be taken into account in national fiscal policy? Is there larger scope for fiscal policy cooperation, and should Fund surveillance promote cooperation more forcefully?
- Do Directors agree with the suggested work agenda?

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### Appendix I — Financial integration and fiscal adjustment: recent evidence
- Sample: 29 advanced and emerging market countries over 1983–2004.
- Dependent variable: change in fiscal deficit after one year, in percent of GDP (ΔDEF).
- Explanatory variables include: central government deficit lagged one year (DEF); log financial integration (FI) = foreign assets and liabilities-to-GDP ratio; index of institutional quality (INS) (ICRG, 0 to 100); log private credit-to-GDP (FD); trade openness (TO); log real GDP per capita (GDPPC).
- Methodology: regressions with country and year fixed effects; interaction terms to assess FI effects with DEF and INS; all regressors except institutional indices measured in initial year.
- Main empirical findings:
  - Greater financial integration has different fiscal effects depending on institutional quality:
    - Financial integration associated with fiscal loosening in countries with weaker institutions.
    - Financial integration reinforces fiscal consolidation in countries with stronger institutions.
- Key coefficients from Table A1 (selected exact reported values and significance indicators):
  - Central government deficit: -0.33 to -0.32 ([8.14]*** to [7.84]***).
  - Index of institutional quality (INS): -0.13 to -0.12 ([4.40]*** to [4.11]***).
  - Log financial integration (FI): 16.91; 15.89; 18.14; 16.99; 17.16; 18.19; 16.01; 17.24 ([4.76]*** to [4.66]***).
  - FI × DEF: -0.12 to -0.11 ([1.87]* to [1.69]*).
  - FI × INS: -0.22 to -0.19 ([5.15]*** to [4.52]***).
  - Log private credit-to-GDP (FD) when included: 0.77 to 0.83 ([1.77]* to [1.89]*).
  - Trade openness (TO): -1.65 to -1.81 ([1.49] to [1.63]).
  - Log real GDP per capita (GDPPC): 0.25, 0.17, 0.38, 0.30 ([0.16] to [0.24]).
- Regression diagnostics:
  - Observations: 436.
  - Number of countries: 29.
  - R2: 0.31 to 0.32.
- Institutional subcomponents (Table A2) — selected interactions:
  - FI × BUREAU (Bureaucracy Quality Index, 0–4): -1.94 ([2.38]**).
  - FI × GOVSTAB: -0.19 ([1.59]).
  - FI × LAWORDER: 0.10 ([0.31]).
  - Interpretation: efficient bureaucracies (BUREAU) play significant role in avoiding fiscal loosening and reinforcing adjustment with higher financial integration.
- Financial sector development:
  - Adding log private credit-to-GDP (FD) does not affect FI significance.
  - FD coefficients suggest greater financial sector development may be associated with scope to loosen fiscal policy: FD = 0.77 to 0.83 ([1.77]* to [1.89]*).
- Robustness: fiscal adjustment over different horizons (Table A3)
  - Coefficients across horizons (exact reported values and t statistics where provided):
    - Central government deficit (DEF): -0.32 (1 year) [7.95]***; -0.28 (2 years) [10.69]***; -0.26 (3 years) [13.65]***; -0.25 (4 years) [16.50]***.
    - Index of institutional quality (INS): 15.89 (1 year) [4.42]***; 11.43 (2 years) [4.77]***; 9.52 (3 years) [5.02]***; 7.33 (4 years) [4.70]***.
    - FI × DEF: -0.11 (1 year) [1.74]*; -0.11 (2 years) [2.86]***; -0.09 (3 years) [2.94]***; -0.07 (4 years) [2.85]***.
    - FI × INS: -0.19 (1 year) [4.54]***; -0.14 (2 years) [4.84]***; -0.11 (3 years) [5.10]***; -0.09 (4 years) [4.84]***.
  - Observations and fit by horizon:
    - Observations: 436 (1 year), 421 (2 years), 391 (3 years), 362 (4 years).
    - Number of countries: 29 (all horizons).
    - R2: 0.31 (1 year), 0.44 (2 years), 0.57 (3 years), 0.67 (4 years).
  - Conclusion: contributions of financial integration remain statistically significant at all four horizons, indicating persistent effects.

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*Italic: Source — Excerpt from IMF content unit _111607a.*

### Executive Summary ......................................................................................................

### _111607a - Executive Summary ......................................................................................................

### Executive Summary — Main Conclusions
- Globalization and financial deepening have the potential to raise economic growth and improve the overall fiscal position, but they could also put pressure on government finances.
- Revenue has been generally robust, but could decline if tax competition intensifies; strengthening tax administration and promoting cooperation designed to avoid harmful tax practices will gain in importance.
- Upward pressure on expenditure may arise from increased demand for social protection and infrastructure investment.
- Contingent fiscal liabilities in the financial sector could increase.
- If fiscal pressures materialize, fiscal policy should be prepositioned to respond by adjusting revenue and expenditure or having the capacity to borrow; this strengthens the case for early fiscal adjustment in countries with debt sustainability concerns.
- Prepositioning and fiscal adjustment needs should account for likely deterioration in fiscal positions due to future expenditure pressures from population aging and climate change (Section II).
- Reaping benefits requires a commitment to fiscal discipline: financial globalization could enhance market discipline but also facilitate excessive borrowing, especially where fiscal frameworks are weak.
- Sound fiscal policies and institutions, careful fiscal monitoring, and timely responses will help sustain trends in “redemption from original sin” and “increased debt tolerance” (Section III).
- Fiscal policy can, in some situations, respond to adverse macroeconomic consequences of large capital inflows; if inflows create or reflect aggregate demand pressure, fiscal stabilization may be appropriate and effective, though this is country specific (Section IV).
- Globalization amplifies fiscal policy spillovers, strengthening the case for enhanced policy cooperation, particularly in the face of common shocks such as population aging (Section V).
- The paper surveys analytical and empirical work, draws policy implications, and identifies areas where further analysis is needed; a work agenda is outlined (Section VI).

### Key cross-cutting messages
- The paper focuses on macrofiscal aspects of globalization and financial deepening and notes that many fiscal-dimension topics (distributional, labor market, trade consequences, structural fiscal issues, fiscal–financial market interactions, pensions) are not covered.
- Sections II and V are more applicable to industrial countries; Sections III and IV apply more to emerging market countries (and to some extent to developing countries).

### Analytical approach
- The approach is largely a stock-taking of what is known and unknown; where the literature is inconclusive or the theoretical outcome unclear, the paper identifies needs for further analysis.
- The paper emphasizes country-specific assessment and the role of institutions and fiscal frameworks.

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### I. Introduction — Framing and scope
- Globalization defined as increasing trade and financial openness; capital flows have picked up sharply in recent years.
- Financial deepening: financial sector growth in economic importance.
- Potential benefits: capital allocation to productive uses, deeper domestic markets, increased efficiency and growth potential.
- Potential policy consequences require appropriate responses; fiscal policy choices and options are affected.
- Paper structure:
  - Section II: fiscal impact of globalization (revenue, expenditure, contingent liabilities).
  - Section III: consequences for fiscal discipline (market discipline, access to financing, debt structure, growth prospects).
  - Section IV: role of fiscal policy, especially toward capital inflows.
  - Section V: spillovers and policy cooperation.
  - Section VI: policy implications and work agenda.
  - Section VII: issues for discussion.
- Note on coverage: focus on macrofiscal aspects; many topical fiscal dimensions excluded; relevance varies by country group.

---

### II. The Fiscal Impact of Globalization and Financial Deepening — A. Tax Revenue (findings and evidence)
- Concern: globalization could increase tax competition and reduce ability to tax mobile factors, especially corporate taxation.
- Observed trend in corporate taxation:
  - In industrial countries, statutory corporate tax rates declined over the past two decades from an average of around 45 percent to around 35 percent.
  - Poland: statutory corporate tax rate reduced from 38 percent in 1997 to 19 percent in 2007.
  - Czech Republic: reduced from 41 percent to 25 percent over a similar period.
  - Emerging market countries in Europe, and emerging markets in Asia and Latin America, also show recent declines in corporate tax rates.
- Despite rate declines, corporate tax revenue has held up:
  - Industrial countries experienced an increase in corporate tax revenue on average, both relative to GDP and to total tax revenue.
  - In emerging market countries, corporate tax revenue now accounts for almost 20 percent of total tax revenue—the highest ratio recorded for these countries.
- Explanations for declining rates but rising revenue:
  - Earlier strengthened pace of economic activity and record-high profits in many countries.
  - Effective corporate tax rates have fallen much less than statutory rates.
  - Corporate tax base broadening: cutting back exemptions and strengthening tax administration.
  - Other contributors:
    - Increased share of profits in GDP.
    - Increased volatility of profits with only partial loss-carryover.
    - Shift from personal to corporate taxation as lower corporate tax rates encouraged small businesses to incorporate.
    - Shift from debt to equity financing; revenue-enhancing insofar as debt is tax deductible while equity generally is not (despite attempts to equalize taxation of debt and equity).
- Outlook and risks:
  - As cyclical factors abate and scope for further base broadening shrinks, additional lowering of tax rates on mobile factors could reduce tax revenue.
  - This could lead to heavier taxation of less mobile factors, exacerbating tax distortions and equity concerns.
  - Growth of electronic commerce, offshore financial centers, and new financial instruments (especially derivatives) could make monitoring economic activity and profits more difficult, with adverse consequences for tax compliance.
- Policy responses and international cooperation:
  - Initiatives focus on cooperative approaches to tax policies and tax administration aimed at containing harmful tax practices, not harmonizing rates or bases.
  - This cooperation may be especially significant for developing countries with limited market access that depend on protecting revenue base.
  - Net welfare effects of cooperation are unclear; some degree of tax competition can be welfare-enhancing.

### II. The Fiscal Impact of Globalization and Financial Deepening — Other aspects (summary)
- Sections on Expenditure, Contingent Liabilities, and Responding to Fiscal Pressure (Section II.B–II.D) are part of the paper but detailed content beyond Tax Revenue is not included in the supplied excerpt.

---

*This paper was prepared by a staff team from the Fiscal Policy and Surveillance Division of FAD. The main contributors to the paper were Manmohan S. Kumar, David Hauner, Jiri Jonas, and Daniel Leigh. Additional input was provided by Richard Hemming, Steven Symansky, Xavier Debrun, Steven Barnett, Alexander Plekhanov, Daehaeng Kim, and Mark De Broeck.*

### 9.      Financial deepening also has implications for tax policy as the financial sector

### _111607a - 9.      Financial deepening also has implications for tax policy as the financial sector

### Tax policy and financial deepening
- Financial deepening can reduce revenue volatility by increasing the private sector’s ability to smooth income in response to shocks, but can also increase revenue volatility because financial sector income tends to be more volatile than that of other sectors (example: Hong Kong).
- VAT treatment of financial services remains debated due to bundling of intermediation and services (e.g., asset management).
  - Most countries exempt financial services from VAT.
  - Some countries (e.g., New Zealand, Singapore) switched to zero-rating so that financial institutions can claim VAT credits for inputs (Zee, 2004). The revenue impact of zero-rating is unclear.
- Relative taxation of equity and debt is being revisited (example: Germany recently limiting the tax deductibility of interest), with likely effects on capital structure as suggested by cross-country evidence (Figure 6).
- Figure 6 (Averages across groups of countries, in percent) — reported indicators associated with relative taxation categories:
  - 142.3
  - 26.1
  - 7.5
  - 19.7
  - 77.6
  - 19.9
  - 14.2
  - 41.1
  - 72.0
  - 18.2
  - 22.9
  - 36.9

### Expenditure pressures and globalization
- Two trends likely to increase demand for public spending despite downward revenue pressure:
  - Increased inequality prompting calls for more social protection and income support/training for low-skilled workers affected by trade opening.
  - Need to invest in economic and social infrastructure to remain competitive; private sector and public-private partnerships can help, but additional public investment remains crucial. Possible expenditure competition (e.g., employment subsidies) to attract foreign investors.
- Empirical evidence on globalization’s impact on public expenditure is mixed:
  - Trade openness may stimulate higher government spending (Rodrik, 1998).
  - Increased financial globalization (Liberati, 2006), and trade openness combined with financial globalization (Garrett and Mitchell, 2001) lead to lower government spending.
  - Findings differ by data scope (central government focus) and controls on capital flows.
- Other looming expenditure pressures:
  - Retirement of the baby boom generation and rising longevity: EU25 estimates indicate average expenditure increase by 2050 likely to be around 3½ to 4 percent of GDP (Economic Policy Committee of the European Union, 2006).
  - Climate change adaptation and mitigation: annualized cost of greenhouse gas mitigation consistent with stabilizing the stock of greenhouse gases is estimated at 1 percent of global GDP (IMF, 2007a).

### Contingent liabilities from the financial sector
- Financial sector is a common source of government contingent liabilities, primarily from bailouts to avoid contagion and protect depositors.
- Typical assistance sequence: containment (deposit guarantees, low-cost credit) followed by restructuring (write-offs, recapitalization).
- Fiscal costs of containment and restructuring have often been large (Figure 7).
- Financial crises tend to follow periods of rapid financial liberalization and innovation due to excessive credit growth and deteriorating lending standards, especially when combined with large capital inflows.
  - Empirical example: 18 out of 26 banking crises in industrial and developing countries during the 1980s and 1990s occurred within five years of substantial financial liberalization (Kaminsky and Reinhart, 1999).
- Globalization and financial deepening raise financial risks in the short run (rapid market activity expansion, new instruments, increased global liquidity, higher risk appetite). A rise in risk aversion could cause large corrections, especially in credit derivatives.
- Recent market developments (sub-prime repricing) had global repercussions, including bailouts and nationalizations (examples referenced: two medium-sized partly state-owned German banks; UK nationalization of a mortgage lender; proposals in the U.S. to ease household mortgage burdens).
- In some large emerging markets, financial sector contingent liabilities under severe stress scenarios are still estimated to be in the range of 30–40 percent of GDP.
- Reference: Standard and Poor’s (2007) “bottom-up” stress-testing estimates of contingent liabilities.

### Responding to fiscal pressure
- Fiscal policy should be prepositioned to retain maneuvering room rather than assume speculative adverse outcomes will materialize.
- Key elements of prepositioning:
  - Develop capacity to increase revenue, reduce expenditure, and/or borrow more should fiscal pressures emerge.
  - Undertake early fiscal adjustment in countries facing actual or potential debt sustainability difficulties.
  - Avoid procyclical fiscal responses, especially during good times.
- Aim: ensure pressures from globalization do not create debt sustainability concerns or necessitate harmful ad hoc fiscal adjustment.

### Consequences for fiscal discipline — Role of market discipline
- Markets exercise fiscal discipline mainly through the impact of fiscal deficits on the credit risk premium on government debt.
  - For highly rated countries, the actual credit risk premium tends to respond by around 5 basis points to each 1 percentage point change in deficit or debt ratio.
  - In emerging market countries, a one percentage point of GDP increase in the deficit has been found to raise foreign and domestic currency interest rate spreads by about 20 and 30 basis points respectively, with a stronger response if deficit increases are due to higher government consumption.
- Market reactions are often non-linear: modest for a range of outcomes but strong once deficits/debt exceed certain thresholds.
- Financial globalization could strengthen market discipline if international investors monitor fiscal policies more closely and are less susceptible to domestic pressures, but external developments (e.g., reduced investor risk appetite) can also trigger sharp market responses.
- Financial globalization could weaken fiscal discipline in the short term by dampening the visible cost of government borrowing (more ready access to external financing), potentially tempting governments to postpone adjustment.
- Empirical evidence on financial globalization and fiscal discipline is inconclusive:
  - Kim (2003): capital account liberalization associated with lower fiscal deficits.
  - Tytell and Wei (2004): de facto financial globalization appears to have no significant impact on fiscal deficits.
  - Abiad and others (2008): financial globalization enhances fiscal discipline in countries with good institutions, but in absence of such institutions and with low initial government debt stock leads to weaker discipline.
- Dual approach recommended:
  - Strengthen market discipline (greater market openness, reduction in domestic captive financing sources, increased transparency about government borrowing and public debt).
  - Strengthen fiscal policies and institutions to reinforce market discipline.

### Consequences for fiscal discipline — Redemption from original sin
- Original sin: difficulty for developing countries to borrow in international markets in their own currency, leaving public debt exposed to currency risk and vulnerable to external shocks.
- Currency depreciations have caused significant jumps in public debt-to-GDP ratios in several crisis countries (Figure 8).
- Since Colombia’s pioneering external issuance of local currency debt in 2004, other emerging markets (e.g., Brazil, Mexico, Uruguay) followed, reflecting redemption from original sin.
- Indicators of redemption:
  - Falling ratio of external to total public debt across emerging countries (Figure 9).
  - Rising share of domestic debt held by nonresidents in a number of countries (Figure 10).
    - Example share comparisons: June 2002 vs June 2006 for selected countries (In percent): Kenya, Korea, Brazil, Malaysia, Mexico, Indonesia, Zambia, Poland, Hungary (figure shows increases; precise chart values in source).
- Improvement in terms of issuing domestic debt:
  - New domestic currency debt increasingly issued with fixed coupons and long maturities (examples: Mexico issued a fixed coupon 30-year bond; Brazil, Colombia, Indonesia, Russia issued 10-year or longer fixed coupon bonds).
  - A standardized measure of domestic original sin fell significantly between 1998 and 2004 in most emerging market countries.
- Table 1. Redemption from Domestic Original Sin — Long-term fixed-rate domestic debt / Total domestic debt (selected markets, values):
  - Brazil 1.00 1.00 0.98
  - Turkey 0.89 0.90 0.66
  - Mexico 1.00 0.85 0.61
  - Colombia ... 0.67 0.56
  - Indonesia 0.80 0.56 0.50
  - Bulgaria 0.84 0.49 0.35
  - Hungary 0.64 0.51 0.33
  - Egypt 0.52 0.24 0.29
  - Czech Republic 0.59 0.56 0.22
  - India 0.05 0.05 0.07
  - Russia 0.07 0.13 0.03
- Note: Domestic original sin is measured as 1 – (Long-term fixed-rate domestic debt / Total domestic debt).

*Source: Excerpt from the IMF chapter/section provided in the content unit.*

### 26.      Inherent problems with global financial markets and weak policies were mainly

### _111607a - 26.      Inherent problems with global financial markets and weak policies were mainly

### Redemption from original sin: causes, benefits, and caveats
- Causes of original sin
  - Market problems: high transactions costs and informational asymmetries led foreign investors to hold only a handful of currencies, making it difficult for many governments to issue debt externally in their own currency.
  - Weak policies: increased the risk that governments would inflate away debt denominated in local currency (Jeanne, 2003).
- Factors contributing to redemption
  - Developments in global financial markets, including ample global liquidity until the first half of 2007, a growing number of dedicated emerging-market investors, and the creation of new instruments.
  - Improvements in domestic policies and institutions, and greater transparency (Lipsky, 2007).
  - Result: increased debt tolerance because improved composition of debt reduces risk associated with any particular level of debt (Reinhart, Rogoff, and Savastano, 2003), implying countries can sustain higher debt burdens.
- Benefits of redemption
  - Larger share of debt issued in domestic currency (assuming tradable) and more flexibility in maturities reduce vulnerability to balance sheet risks.
  - Opportunities to lower government financing costs.
  - Potential contributions to financial development (improved market infrastructure), risk-sharing, and growth benefits.
  - Government revenue (including seignorage) will respond to higher growth.
- Caveats and risks
  - Balance needed between local and foreign currency debt to avoid temptation to inflate away local currency debt and to prevent heavy government borrowing from harming banking sector efficiency and development (Hauner, 2008).
  - Spreads on foreign currency debt remain a useful measure of country risk and a benchmark for corporate bonds.
  - Redemption may increase exchange rate volatility because foreigners tend to trade more actively than local residents.
  - Uncertainty whether redemption is temporary or permanent; original sin might reassert during prolonged periods of limited global liquidity and risk appetite.
  - Policy recommendation: bolstering credibility by committing to fiscal discipline can help make redemption more likely to be permanent.
- Note from source (footnote)
  - One proposed solution was to create emerging-market currency baskets and let international institutions or G-10 governments issue debt in the resulting currency units (Goldstein and Turner, 2004). 15

### Growth, financial development, and debt tolerance
- Relationships identified
  - Positive relationship between financial development and economic growth (Levine, 1997), with some heightened short-term financial crisis risk.
  - Positive relationship between trade openness and growth (Lopez, 2005); causality appears to run from openness to growth (Somalis, 2007).
  - Trade openness tends to reduce frequency of financial crises (Martin and Rye, 2006), though many low-income countries have not yet seen benefits (IMF and World Bank, 2007).
- Financial globalization and growth: mixed evidence
  - Foreign direct investment and other non-debt creating inflows are positively associated with longer-term growth.
  - Impact of debt-creating inflows depends on strength of a country’s policies and institutions.
  - Identification complications: removal of capital outflow restrictions may put upward pressure on interest rates; higher short-term probability of financial crises after liberalization may obscure long-term growth benefits (Rancière, Tornell and Westermann, 2006); longer-term benefits often occur via indirect channels such as financial development, stronger macroeconomic policies, and better governance (Kose and others, 2006).
- Financial globalization and macroeconomic volatility: ambiguous
  - Could reduce volatility via increased risk sharing (seen in industrial countries).
  - Could increase volatility via abrupt capital flow reversals and boom-bust cycles in countries with underdeveloped financial markets.
  - Empirical evidence suggests no significant impact of financial globalization on volatility overall (IMF, 2007c), especially for countries with well-developed financial markets and better institutions (Bekaert, Harvey, and Lundblad, 2006; Martin and Rey, 2006).
- Implications for debt tolerance
  - Globalization and financial deepening that increase growth and lower volatility will tend to increase debt tolerance.
  - Higher growth increases sustainable debt levels directly and via positive effects on non-debt-creating capital inflows.
  - Lower volatility (smaller and less frequent shocks) increases debt tolerance by reducing likelihood that debt becomes unsustainable.
  - Benefits more likely for countries with relatively well-developed financial systems and institutions pursuing sound policies.
  - Policy recommendation: governments should credibly commit to fiscal discipline.

### Role of fiscal policy: stabilization and responses to capital flows
- Fiscal stabilization: key points
  - Fiscal policy has roles in resource allocation, redistribution, and stabilization amid increased capital flows.
  - Debate exists on appropriateness and effectiveness of fiscal stabilization (size and sign of fiscal multipliers).
  - Globalization and financial deepening can make fiscal multipliers either larger or smaller.
    - Crowding out via the interest rate channel is reduced as capital mobility increases.16
    - Under a fixed exchange rate with high capital mobility, fiscal policy becomes more effective (monetary policy must support the exchange rate). Under flexible exchange rates, exchange rate movements can offset fiscal demand impacts, weakening effectiveness; in the limit, fiscal policy can become totally ineffective.
    - Credibility effects of fiscal policy influence multipliers through private sector expectations; effects depend on initial debt stock, financing of deficits, and nature of revenue/expenditure measures.
- Trade openness and fiscal multipliers
  - Trade openness likely reduces fiscal multipliers modestly via leakage through imports.
  - Evidence: less than 10 percent of a change in the fiscal balance feeds through to the current account for OECD countries (Bussière, Fratzscher, and Müller, 2005); relationship rarely statistically significant.
  - Dellas, Neusser, and Wälti (2006) do not find a statistically significant link between trade openness and fiscal multipliers.
- Financial deepening and fiscal stabilization
  - Financial deepening enables countercyclical fiscal policy; with shallow markets governments can be forced into procyclicality.
  - Deeper markets may lessen government borrowing effects on domestic interest rates and country risk premia, reducing crowding out and increasing fiscal stabilization effectiveness.
  - Countervailing effects: lifting financial repression removes a captive source of finance and may make domestic interest rates more sensitive to fiscal policy; improved access to private credit may allow households to smooth consumption (Ricardian equivalence), offsetting fiscal measures.
  - Net impact on multipliers depends on dominant effects.
- Empirical indication of procyclicality and financial development
  - Figure 11: Index of Fiscal Policy Procyclicality vs Private Sector Credit-to-GDP Ratio (in percent), N= 85 (source: Fund staff calculations based on Kaminsky, Reinhart, and Végh (2004) and World Bank dataset).
- Financial globalization and fiscal multipliers
  - Similarities with financial deepening: borrowing on global markets dampens domestic factors’ impact on domestic interest rates, reducing crowding out and increasing fiscal multipliers.
  - Economic size matters because large-country borrowing could influence global interest rates.
  - Evidence: access to a larger pool of foreign savings has reduced the impact of government deficits on interest rates for large industrial countries (Hauner and Kumar, 2006; European Central Bank, 2006).
  - Aisen and Hauner (2008): effect of deficits on interest rates is smaller for financially more open economies.
  - Potential adverse effect: under flexible exchange rates, small interest rate increases can trigger capital inflows and appreciation that offset fiscal expansion; if fiscal sustainability is in doubt, market reactions may make interest rates more sensitive to fiscal policy, producing expansionary fiscal contractions or fiscal expansions that reduce activity.
- Fiscal policy response to capital flows: guidance and caveats
  - Capital flows raise fiscal policy challenges; whether fiscal tightening is appropriate depends on causes and consequences of flows.
  - Fiscal loosening may be appropriate in outflows that lack fiscal cause/consequence if the fiscal position is sustainable and financing is available (example: Korea in 1997).
  - For inflows, appropriateness of fiscal response depends on macroeconomic imbalances, reasons for inflows, exchange rate regime, size and openness of economy, and initial fiscal position.17
  - Fiscal tightening is often appropriate when inflows are supply-determined and temporary (changes in liquidity, investor risk appetite, market sentiment).18
    - Tightening can relieve demand pressure and lower domestic interest rates, especially with monetary easing.
    - Tightening (possibly with exchange rate adjustment) may be appropriate if inflows finance a large current account deficit.
    - Country experience: fiscal tightening commonly used in response to flow surges that lead to overheating; sometimes combined with accelerated debt repayment (Box 1).
  - Cases where fiscal tightening may be inappropriate
    - If there is a large current account surplus, fiscal tightening could exacerbate imbalances.
    - Tightening that improves credibility could attract still more inflows, making it counterproductive (Roubini, 2007).
    - Some countries with already large fiscal primary surpluses find further tightening difficult (e.g., Estonia and Turkey).
    - For structurally higher inflows reflecting real investment opportunities (Central and Eastern Europe, emerging Asia), real or nominal appreciation may be more appropriate; fiscal tightening can still slow appreciation and avoid procyclicality/overheating.
    - Other options: sterilized exchange market intervention and controls on capital inflows/outflows, but these have well-known limitations.
    - Implementation lags: fiscal policy may not respond fast enough; automatic stabilizers reduce this problem though discretionary measures may be needed for equity concerns.19
- Empirical correlations and policy outcomes
  - Central and Eastern Europe: lower fiscal deficits tend to be associated with higher net capital inflows (Figure 12, upper chart).
    - Uncertainty whether lower deficits reflect policy tightening or revenue boosts from credit-driven consumption booms.
    - In countries that tightened fiscal policy, it is difficult to determine whether tightening was response to flows or prompted them.
  - Lower fiscal deficits are associated with less real exchange rate appreciation in Central and Eastern Europe (Figure 12, lower chart), despite larger capital inflows.
  - Broader sample evidence: countries responding to inflows with fiscal tightening experienced smaller exchange rate appreciation than those that intervened in foreign exchange markets or tightened controls on capital inflows (IMF, 2007a).20

*Source: _111607a - 26.      Inherent problems with global financial markets and weak policies were mainly*

### Box 1. Selected Fiscal Policy Responses to Capital Inflows

### Box 1. Selected Fiscal Policy Responses to Capital Inflows

### Historical episodes and country responses
- Surge in capital flows to emerging markets during the first half of the 1990s led a number of countries to undertake fiscal tightening in response to overheating concerns.
- Fiscal adjustment sometimes preceded inflows and may have been a continuation of pre-inflow consolidation.
- Selected country episodes and periods (as listed):
  - Indonesia: 1990–94 (Accelerated debt repayment, 1994)
  - Korea: 1992–94
  - Malaysia: 1988–94
  - Philippines: 1990–95 (Accelerated debt repayment, 1994–95)
  - Thailand: 1988–91 (Accelerated debt repayment, 1988–90)
  - Argentina: 1991–93
  - Chile: 1989–95
  - Mexico: 1989–93
  - Czech Rep.: 1996–97
- Source for the episodes: World Bank.

### Regional patterns and notable country cases
- Central and Eastern Europe (EU accession-related inflows): Most countries did not tighten fiscal policy; main exceptions were the Baltic countries. Instead, currencies were allowed to appreciate in nominal and real terms, helping keep inflation relatively low.
- Asia (recent years relative to period discussed): Despite overheating concerns, fiscal tightening has played a relatively small role; automatic stabilizers have been allowed to operate in some countries. Policy focus centered on exchange rate flexibility and appreciation of perceived undervalued currencies.
- Estonia: Large capital inflows pressured the currency board. Fiscal policy is the main available instrument, but the general government balance is already in surplus and gross public debt negligible, limiting scope for further tightening. Consideration given to shifting public expenditure away from the nontraded sector (construction), which contributed to inflation.
- Turkey: Large inflows under a floating currency caused appreciation and competitiveness concerns. High primary fiscal surplus makes further fiscal tightening considered neither desirable nor feasible. With inflation above target range, monetary easing and fiscal policy must be appropriately balanced.

### Composition of fiscal responses and tax policy implications (paragraph 44)
- When fiscal tightening is appropriate, composition should depend on country-specific circumstances.
- Political economy considerations can make tax increases easier, but well-targeted spending cuts:
  - Can increase overall expenditure efficiency.
  - Can provide room to reduce excessively high taxes, yielding beneficial supply-side effects.
- Tax system structure affects effectiveness of fiscal response:
  - Emphasis on taxation of nontraded goods (e.g., real estate) raises revenue when inflows and real exchange rate appreciation shift resources into nontradables (Eichengreen and Choudhry, 2005).
- Tax policies can help reduce risk of asset price bubbles; example cited:
  - China introduced tax measures to stabilize the real estate market, including a capital gains tax and value-added tax on land (Asian Development Bank, 2007).

### Empirical evidence on expenditure restraint and outcomes (paragraph 45; Table 2)
- Experience from Asia and Latin America in the first half of the 1990s:
  - Asian countries (Malaysia, Thailand, Indonesia, Singapore) and Chile applied significant expenditure restraint.
  - Most Latin American countries and the Philippines allowed a procyclical increase in spending.
- Fiscal tightening reduced pressure on monetary policy; countries with more expenditure restraint experienced substantially lower real exchange rate appreciation during high inflows.
- Tighter fiscal policy during peak inflows created room to cushion subsequent reversals by raising spending (examples: Malaysia and Thailand).

- Table 2: Fiscal Policy Response to Capital Flows — episodes and exact figures (Change in Net Capital Inflow; Real Exchange Rate Appreciation; Deviation of Government Expenditure-to-GDP Ratio (Average during the episode relative to the average over three preceding years), 1985–2000 average)
  - Malaysia, 1989–96 — 5.7; 6.9; -2.3
  - Thailand, 1987–95 — 9.1; 5.5; -1.6
  - Chile, 1989–97 — 5.6; 18.6; -1.3
  - Indonesia, 1990–96 — 1.6; 8.1; -1.0
  - Singapore, 1987–92 — 7.1; 2.3; -0.9
  - Korea, 1990–96 — 5.5; 7.4; 0.2
  - China, 1993–96 — 5.0; -6.8; 0.4
  - Brazil, 1992–96 — 3.9; 14.7; 0.8
  - Peru, 1992–97 — 9.0; 19.7; 1.5
  - Philippines, 1989–96 — 4.8; 11.2; 1.9
  - Mexico, 1989–93 — 6.9; 33.8; 1.9
  - Colombia, 1992–96 — 3.9; 18.1; 2.3
  - Argentina, 1990–93 — 8.8; 43.5; 2.6
- Sources for Table 2: International Financial Statistics and Athukorala and Rajapatirana (2003).

### Simulations of fiscal spillovers under financial integration (paragraphs 46–51; Figures 12–14)
- Theoretical background: Fiscal policy externalities can be positive (demand for imports) or negative (terms-of-trade improvements; global loanable funds reduction raising world interest rates). Magnitude and sign depend on revenue/spending composition, behavioral responses, home bias, and other factors.
- Financial globalization likely amplifies interest rate spillovers; deeper trade integration may increase demand-side spillovers via imports.
- Empirical evidence is mixed; some studies find significant positive spillovers within the EU (e.g., a 1 percent of GDP public spending stimulus in Germany boosts activity in EU trading partners by almost ¼ percent of GDP on average), but estimates depend on nature of fiscal action and degree of financial globalization.

- GIMF simulations (Fund staff) of a permanent U.S. fiscal consolidation:
  - Scenario setup:
    - United States undertakes fiscal consolidation that permanently reduces its public debt-to-GDP ratio by 15 percentage points.
    - Consolidation is front loaded.
    - Long-term overall budget balance must remain permanently higher than in the no-consolidation baseline by 0.5 percent of GDP.
  - Low-integration vs. high-integration scenarios:
    - In the low-integration scenario, the interest rate on a country’s debt includes a country-specific premium which increases with the country’s external borrowing.
    - The long-run response of interest rates is only half as large in the high-integration scenario (i.e., high integration attenuates country-specific premium effects on domestic interest rates).
  - Key numeric simulation outcomes (exactly as reported):
    - In limited financial integration:
      - U.S. current account improves by 0.1 percent of GDP.
      - Domestic real interest rates decline six times more than world interest rates.
      - Permanent output gain of 5 percent (concentrated in the United States).
    - In high financial integration:
      - U.S. current account improves permanently by 0.3 percent of GDP.
      - Larger part of additional U.S. saving leaks abroad; additional income from accumulation of net foreign assets contributes to a steady decline in global interest rates.
      - World interest rates remain permanently lower.
      - Crowding in is shared evenly, with a permanent output gain of 3 percent in both the United States and in the rest of the world.
  - Conclusion from simulations: Longer-term spillover effects of fiscal consolidation increase with the degree of financial integration.

### Policy implications drawn in this box
- Composition matters: tax increases may be politically easier, but well-targeted spending cuts can improve expenditure efficiency and enable tax reductions with supply-side benefits.
- Tax structure can help absorb inflow-induced sectoral shifts (taxation of nontradables like real estate).
- Tax measures can be used to limit asset-price bubbles (example: China's capital gains tax and value-added tax on land to stabilize real estate).
- Fiscal tightening during inflow peaks can reduce monetary policy pressure and create space to respond to subsequent reversals.

*Italic: Source — _111607a - Box 1. Selected Fiscal Policy Responses to Capital Inflows*

### 55.      Tax and expenditure reform. While there may be room to expand tax bases and

### 55.      Tax and expenditure reform. While there may be room to expand tax bases and

### Tax and expenditure reform
- Finding: There may be room to expand tax bases and strengthen administration, but only limited scope for additional taxation of immobile factors for efficiency and equity reasons.
- Finding: Administrative difficulties arise, especially for developing countries that have already faced difficulties shifting from “easy to collect” taxes such as tariffs to “hard to collect” income taxes and VAT (Aizerman and Jinjarak, 2006).
- Recommendation: Action on the expenditure side is the most likely and desirable option, given the well-established link between high-quality spending cuts and successful fiscal adjustment.
- Recommendation: Expenditure restructuring should be anchored by a thorough review of public expenditure to identify scope to reduce spending and alter its mix.
- Recommendation: The public expenditure review should specifically assess the appropriate size and structure of social protection in a more open economy and gauge the need for, and identify measures to, mitigate the poverty and social impacts of globalization.

### Financial sector contingent liabilities (section 56)
- Finding: Contingent liabilities can create problems for government solvency and liquidity.
- Recommendation: Identify, quantify, and disclose explicit contingent liabilities and formally incorporate them into debt sustainability analysis.
- Recommendation: Increase awareness of implicit contingent liabilities (or stand-behind obligations).
- Recommendation: Adopt timely intervention strategies emphasizing preemptive restructuring of at-risk financial institutions to reduce fiscal costs of contingent liabilities.
- Recommendation: Strengthen supervision to help prevent and manage contingent liability risks.

### Fiscal policies and institutions (section 57)
- Finding: Globalization and financial deepening can help ensure redemption from original sin and possibly increase debt tolerance.
- Recommendation: Credible commitment to sound fiscal policies is required to fully reap benefits.
- Policy instruments with potential to enhance credibility:
  - Fiscal rules.
  - Fiscal responsibility laws (with heavy emphasis on fiscal transparency).
  - Independent fiscal councils.
- Recommendation: Emphasize ability to monitor fiscal developments and respond in a timely manner.
- Recommendation: Combine measures to enhance market scrutiny with institutional reform to strengthen fiscal frameworks.

### Effectiveness of fiscal stabilization (section 58)
- Finding: Globalization and financial deepening are likely to influence the effectiveness of fiscal stabilization, but evidence is far from clear.
- Theory suggests key factors to consider when assessing effectiveness:
  - Exchange rate regime.
  - Sensitivity of capital flows to interest rates.
  - Fiscal policy credibility.
- Recommendation: Avoid unnecessarily large changes in risk premia and interest rates in response to fiscal expansions and contractions.
- Recommendation: Reassure financial markets about fiscal credibility to limit destabilizing market responses.

### Fiscal response to capital inflows (section 59)
- Finding: Fiscal policy can play a stabilization role in response to capital inflows.
- Guidance:
  - If inflows create or reflect aggregate demand pressure, fiscal stabilization may be appropriate.
  - If inflows are due to supply factors (e.g., global liquidity) or driven by a current account deficit, there is a stronger case for fiscal adjustment bearing the brunt.
  - If an increase in capital inflows is considered permanent, adjustment should occur mainly through the real exchange rate, or by loosening controls on capital outflows.
  - Fiscal policy can still help ease the path of exchange rate adjustment even when exchange-rate-based adjustments are primary.

### Policy cooperation (section 60)
- Finding: Globalization magnifies fiscal policy spillovers, strengthening the case for enhanced policy cooperation for common and longer-term challenges (e.g., population aging, climate change).
- Finding: Some tax competition can be beneficial, including for government efficiency (Parry, 2003), but cooperation may be needed to limit harmful tax practices.
- Finding: Effects of tax competition differ between industrial and developing countries; developing countries often have limited recourse to other financing sources.
- Role of the Fund:
  - Multilateral and bilateral surveillance can contribute substantially by rigorous technical analysis of spillovers and externalities.
  - Establish a common analytical framework to promote constructive dialogue.
  - Foster peer pressure and discourage deviations from mutually beneficial policies.

### B. Work Agenda (section 61)
- Overall: There are areas where outcomes and appropriate policy responses are not yet identified or understood; proposed work aims to improve understanding and inform policy.
- Specific work items:
  - Examine whether recent declines in corporate tax rates pose a future risk to government finances; a future Board paper will address tax competition issues for developing and industrial countries.
  - Investigate tax policy issues stemming from the growing importance of the financial sector, including corporate income tax volatility, VAT treatment of financial services, and relative taxation of equity and debt.
  - Identify sources of increased demand for spending to guide expenditure responses; continue work on financing infrastructure investment and designing well-targeted social protection.
  - Improve assessment of the size of contingent liabilities and the likelihood of their realization to properly account for potential fiscal impact, including in the DSA.
  - Study whether better access to external financing strengthens or loosens fiscal discipline; investigate the role of fiscal institutions, determinants of redemption from original sin and debt tolerance, and consequences.
  - Clarify the role of fiscal policy in responding to large capital inflows and determine the appropriate policy mix; study how globalization and financial deepening affect fiscal stabilization effectiveness.
  - Analyze the payoff to specific forms of policy cooperation under well-defined circumstances, including cooperation on demographic challenges and tax policies to encourage firms to reduce greenhouse gas emissions.
  - Examine potential for Fund surveillance to promote cooperation by analyzing coordination failures and fostering dialogue in a multilateral context.
- Budgetary note: This work agenda can be undertaken within the current resource envelope and therefore has no direct budgetary implication.

### VII. Issues for Discussion
- Questions posed for Directors:
  - Do Directors view it as likely that globalization and financial deepening will tend to reduce government revenue and increase public expenditure? If so, should a cooperative policy response to limit harmful tax practices be considered, and should fiscal policy be prepositioned to help countries manage these and other fiscal pressures?
  - How do Directors assess the likely consequences of financial globalization for fiscal discipline? Do Directors see redemption from original sin as temporary or permanent?
  - In what circumstances do Directors view fiscal tightening as an appropriate and effective response to capital inflows? Do Directors have an opinion as to whether globalization and financial deepening have made fiscal stabilization more or less effective?
  - How should cross-border spillovers be taken into account in formulating national fiscal policy? Is there larger scope for fiscal policy cooperation given increased globalization, and should Fund surveillance play a more forceful role in promoting cooperation?
  - Do Directors agree with the work agenda suggested above?

*Source: IMF content unit _111607a - 55. Tax and expenditure reform.*

### REFERENCES

### _111607a - REFERENCES

### IMF and multilateral publications
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### IMF working papers and staff papers (selected)
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- Zee, Howell H., ed., 2004, Taxing the Financial Sector (Washington: International Monetary Fund).
- Kumar, Manmohan S., and Teresa Ter-Minassian (eds.), 2007, Promoting Fiscal Discipline (Washington: International Monetary Fund).

### Journal articles, working papers, and books (selected)
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- Bayoumi, Tamim, Morris Goldstein, and G. Woglom, 1995, “Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States,” Journal of Money, Credit, and Banking, Vol. 27, No. 4, pp. 1046–59.
- Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine, 2000, “A New Database on the Structure and Development of the Financial Sector,” World Bank Economic Review, Vol. 14, No. 3, pp. 597–605.
- Beetsma, Roel M. W. J., 2001, “Does EMU Need a Stability Pact? Fiscal Policy Coordination in EMU: Should It Go Beyond the SGP?” In The Stability and Growth Pact − The Architecture of Fiscal Policy in EMU, ed. by Brunila, A., M. Buti, and D. Franco (New York: Palgrave).
- ______, Debrun, Xavier, and Franc Klaassen, 2001, “Is Fiscal Policy Coordination in EMU Desirable?” Swedish Economic Policy Review, Vol. 8, No. 2, pp. 57–98.
- Beetsma, Roel, Massimo Giuliodori, and Franc Klaassen, 2005, “Trade Spillovers of Fiscal Policy in the European Union: A Panel Analysis,” CEPR Discussion Paper No 5222, (London: Center for Economic Policy Research).
- ______, 2006, “Spillovers in the EU,” Economic Policy, Vol. 21, No. 48, pp. 639–87.
- Bekaert, Geert, Campbell R. Harvey, and Christian Lundblad, 2006, “Growth Volatility and Financial Liberalization,” Journal of International Money and Finance, Vol. 25, No. 3, pp. 370–403.
- Bénassy-Quéré, Agnès, 2006, “Short-Term Fiscal Spillovers in a Monetary Union,” CEPII Working Paper 2006–13 (Paris: Centre d'Etudes Prospectives et d'Information Internationales).
- Bernoth, Kerstin, Jürgen von Hagen, and Ludger Schuknecht, 2004, “Sovereign Risk Premia in the European Government Bond Market,” Working Paper No. 369, (Frankfurt: European Central Bank).
- Borensztein, Eduardo, Marcos Chamon, Olivier Jeanne, Paolo Mauro, and Jeromin Zettelmeyer, 2005, “Sovereign Debt Structure for Crisis Prevention,” IMF Occasional Paper 237 (Washington, DC: International Monetary Fund).
- Bovenberg, Lans, 2006, “International Competition in Corporate Taxation: Evidence from the OECD Time Series: Discussion,” Economic Policy, No. 45, pp. 193–97.
- Branson, William H., Jacob A. Frenkel and Morris Goldstein, eds., 1990, International Policy Coordination and Exchange Rate Fluctuations. The University of Chicago Press.
- Bussière, Matthieu, Marcel Fratzscher, and Gernot J. Müller, 2005, “Productivity Shocks, Budget Deficits and the Current Account,” ECB Working Paper No. 509, August 2005 (Frankfurt: European Central Bank).
- ______, 2006, “Current Account Dynamics in OECD Countries and in the New EU Member States: An Intertemporal Approach,” Journal of Economic Integration, Vol. 21, No. 3, pp. 593–618.
- Caballero, Ricardo J., and Arvind Krishnamurthy, 2004, “Fiscal Policy and Financial Depth,” NBER Working Paper No. 10532 (Cambridge, MA: National Bureau of Economic Research).
- Canzoneri, Matthew, Robert Cumby, and Behzad Diba, 2003, “New Views on the Transatlantic Transmission of Fiscal Policy and Macroeconomic Policy Coordination,” in Buti, Marco (ed.) Monetary and Fiscal Policies in EMU—Interactions and Coordination (Cambridge, UK: Cambridge University Press).
- Canzoneri, Matthew and Dale Henderson, 1991, Monetary Policy in Interdependent Economies: A Game-Theoretic Approach (Cambridge, MA: The MIT Press).
- Celasun, Oya, Xavier Debrun, and Jonathan D. Ostry, 2006, “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A ‘Fan-Chart’ Approach,” IMF Staff Papers (Vol. 53, No. 3), pp. 401–25.
- Clarida, Richard, and Joe Prendergast, 1999, “Fiscal Stance and Real Exchange: Some Empirical Estimates,” NBER Working Paper No. 7077 (Cambridge, MA: National Bureau of Economic Research).
- Dell’Ariccia, Giovanni, and Robert Marquez, 2006, “Lending Booms and Lending Standards,” The Journal of Finance, Vol. LXI, No. 5, pp. 2511–46.
- Dellas, Harris, Klaus Neusser, and Manuel Wälti, 2005, “Fiscal Policy in Open Economies,” Working Paper, Department of Economics (Switzerland: University of Bern).
- Devereux, Michael B., Alexander Klemm, and Rachel Griffith, 2003, “Evaluating Tax Policy for Location Decisions,” International Tax and Public Finance 10, pp. 107–26.
- Eichengreen, Barry, and Omar Choudhry, 2005, “Managing Capital Inflows: Eastern Europe in an Asian Mirror,” Paper presented for the Turkish Central Bank/Center for European Integration Studies Conference on Macroeconomic Policies for EU Accession, Ankara, May 6–7.
- Eichengreen, Barry, and Ricardo Hausman, 1999, “Exchange Rates and Financial Fragility,” in New Challenges to Monetary Policy; Proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City (Kansas City: Federal Reserve Bank of Kansas City), pp. 329–68.
- European Central Bank, 2006, “Fiscal Policy and Financial Markets,” ECB Monthly Bulletin, February, Chapter 3.
- Faini, Riccardo, 2006, Fiscal Policy and Interest Rates in Europe,” Economic Policy, July, pp. 444–89.
- Frankel, Jeffrey, and Katharine Rockett, 1988, “International Macroeconomic Policy Coordination when Policy-makers Disagree on the Model,” NBER Working Paper No 2059 (Cambridge, MA: National Bureau of Economic Research).
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- Garrett, Geoffrey and Deborah Mitchell, 2001, “Globalization, Government Spending and Taxation in the OECD,” European Journal of Political Research, Vol. 39, No. 2, pp. 145–77.
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- Ghosh, Atish, and Paul Masson, 1991, “Model Uncertainty, Learning, and the Gains from Coordination,” American Economic Review, Vol. 81, pp. 465-79.
- Goldstein, Morris, and Philip Turner, 2004, Controlling Currency Mismatches in Emerging Markets (Washington, DC: Institute of International Economics).
- Hallerberg, Mark, and Guntram Wolff, 2006, “Fiscal Institutions, Fiscal Policy, and Sovereign Risk Premia,” Discussion Paper No. 35 (Frankfurt: Deutsche Bundesbank)
- Hamada, Koishi, 1985, The Political Economy of International Monetary Interdependence (Cambridge, MA: The MIT Press).
- Hauner, David, 2008, “Credit to Government and Banking Sector Performance,” forthcoming in Journal of Banking and Finance.
- Hauner, David, 2008, “Financial Conditions and Fiscal Performance in Emerging Markets,” forthcoming in Contemporary Economic Policy.
- Honohan, Patrick, and Daniela Klingebiel, 2003, “The Fiscal Cost Implications of an Accommodating Approach to Banking Crises,” Journal of Banking and Finance, Vol. 27, pp. 1539–60.
- Jensen, Henrik, 1996, “The Advantage of International Fiscal Cooperation under Alternative Monetary Regimes,” European Journal of Political Economy, Vol. 12, No. 3, pp. 485–504.
- Kaminsky, Graciela L., and Reinhart, Carmen M., 1999, “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems,” American Economic Review, Vol. 89, No. 3, pp. 473–500.
- Kaminsky, Graciela L., Carmen M. Reinhart, and Carlos A. Végh, 2004, “When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies,” NBER Working Paper 10780 (Cambridge: National Bureau of Economic Research).
- Kanbur, Ravi, and Michael Keen, 1993, “Jeux Sans Frontieres: Tax Competition and Tax Coordination When Countries Differ in Size,” American Economic Review, Vol. 83, No. 4, pp. 877–92.
- Keen, Michael, 2008, “Tax Competition,” in New Palgrave Dictionary of Economics (New York: Palgrave).
- Kim, Woochan, 2003, “Does Capital Account Liberalization Discipline Budget Deficit?” Review of International Economics, Vol. 11, No. 5, pp. 830–44.
- Korkman, Sixten, 2001,“Fiscal Policy Coordination in EMU: Should It Go Beyond the SGP?” In The Stability and Growth Pact − The Architecture of Fiscal Policy in EMU, ed. by Brunila, A., M. Buti, and D. Franco (New York: Palgrave).
- Krueger, Anne O., 2003, “Market Discipline and Public Policy: The Role of the IMF,” Keynote Address, Conference on Market Discipline, Federal Reserve Bank of Chicago and the Bank for International Settlement.
- Kumar, Manmohan S., and Avinash Persaud, 2002, “Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence,” International Finance, Vol. 5, No. 3, pp. 401–36.
- Lane, Philip R., and Roberto Perotti, 1998, “The Trade Balance and Fiscal Policy in the OECD,” European Economic Review, Vol. 42, No. 3–5, pp. 887–95.
- Levine, Ross,1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35, No. 2, pp. 688–726.
- Liberatti, Paolo, 2006, “Trade Openness, Financial Openness and Government Size,” Università di Urbino Santa Po, Mimeo.
- Lipsky, John, 2007, “Developing Deeper Capital Markets in Emerging Market Economies,” Remarks at the U.S. Department of the Treasury, February 2, 2007.
- López, Ricardo A., 2005, “Trade and Growth: Reconciling the Macroeconomic and Microeconomic Evidence,” Journal of Economic Surveys, Vol. 19, No. 4.
- Marcellino, Massimiliano, 2002, “Some Stylized Facts on Non-Systematic Fiscal Policy in the Euro Area,” CEPR Discussion Paper No. 3635 (London: Center for Economic Policy Research).
- Martin, Philippe, and Hélène Rey, 2006, “Globalization and Emerging Markets: With or Without Crash?” American Economic Review, Vol. 96, No. 5.
- Mehl, Arnaud, and Julien Reynaud, 2005, “The Determinants of Domestic Original Sin in Emerging Market Economies,” ECB Working Paper Series No. 560.
- Mundell, Robert, 1968, International Economics (New York: McMillan).
- Nicodème, Gaëtan, 2006. “Corporate Tax Competition and Coordination in the European Union. What Do We Know? Where Do We Stand?” European Commission Working Paper 250 (Brussels: European Commission).
- Obstfeld, Maurice, and Kenneth Rogoff, 2001, “Global Implications of Self-Oriented National Monetary Rules,” Quarterly Journal of Economics, Vol. 117, No. 2, pp. 503–35.
- OECD, 2000, “Towards Global Tax Co-operation,” Report to the 2000 Ministerial Council Meeting and Recommendations by the Committee on Fiscal Affairs (Paris: Organization for Economic Cooperation and Development).
- Oudiz, Gilles, and Jeffrey Sachs, 1984, “Macroeconomic Policy Coordination among the Industrial Countries,” Brookings Papers on Economic Activity 1, pp. 1–64.
- Parry, Ian W.H., 2003, “How Large are the Welfare Costs of Tax Competition,” Journal of Urban Economics, Vol. 54, No. 1, pp. 39–60.
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*Source: _111607a - REFERENCES.*

### APPENDIX I. FINANCIAL INTEGRATION AND FISCAL ADJUSTMENT: RECENT EVIDENCE

### APPENDIX I. FINANCIAL INTEGRATION AND FISCAL ADJUSTMENT: RECENT EVIDENCE

### Background and methodology
- Sample: 29 advanced and emerging market countries over the 1983–2004 period.
- Dependent variable: change in fiscal deficit after one year, in percent of GDP (ΔDEF).
- Explanatory variables include:
  - Central government deficit lagged one year (DEF).
  - Log financial integration (FI): foreign assets and liabilities-to-GDP ratio.
  - Index of institutional quality (INS) (International Country Risk Guide, 0 to 100 scale).
  - Log private credit-to-GDP (FD).
  - Trade openness (TO): imports and exports-to-GDP ratio.
  - Log real GDP per capita (GDPPC).
- Methodology:
  - Regressions include country and year fixed effects.
  - Econometric methodology follows Alesina, Ardagna and Trebbi (2006).
  - Interaction terms used to assess how FI effects vary with DEF and INS.
  - All regressors, except institutional indices, are measured in the initial year.

### Main empirical findings
- Baseline result: greater financial integration has different fiscal effects depending on institutional quality.
  - Financial integration is associated with fiscal loosening in countries with weaker institutions.
  - Financial integration reinforces fiscal consolidation in countries with stronger institutions.
- Key coefficients from Table A1 (column references reflect table layout):
  - Central government deficit-0.33 to -0.32 (t statistics in brackets range from [8.14]*** to [7.84]***).
  - Index of institutional quality (INS): -0.13 to -0.12 ([4.40]*** to [4.11]***).
  - Log financial integration (FI): values reported 16.91, 15.89, 18.14, 16.99, 17.16, 18.19, 16.01, 17.24 (t statistics [4.76]*** to [4.66]***).
  - FI × DEF: -0.12 to -0.11 ([1.87]* to [1.69]*).
  - FI × INS: -0.22 to -0.19 ([5.15]*** to [4.52]***).
  - Log private credit-to-GDP (FD) where included: 0.77 to 0.83 ([1.77]* to [1.89]*).
  - Trade openness (TO) coefficients shown: -1.65 to -1.81 ([1.49] to [1.63]).
  - Log real GDP per capita (GDPPC) coefficients shown: 0.25, 0.17, 0.38, 0.30 ([0.16] to [0.24]).
- Regression diagnostics:
  - Observations: 436.
  - Number of countries: 29.
  - R2 across specifications: 0.31 to 0.32.

### Institutional features (Table A2)
- Examination of ICRG subcomponents to identify which institutional features matter most:
  - Central government deficit: -0.32 and -0.30 ([7.95]*** and [7.46]***).
  - Log financial integration: 15.89 and 8.09 ([4.42]*** and [3.16]***).
  - FI × DEF: -0.11 and -0.09 ([1.74]* and [1.34]).
  - Log private credit-to-GDP (FD): 0.77 and 0.80 ([1.77]* and [1.78]*).
  - Index of institutional quality (INS): -0.13 ([4.36]***).
  - FI × INS: -0.19 ([4.54]***).
  - Government Stability Index (GOVSTAB, 0–12 scale): -0.10 ([0.87]).
  - Bureaucracy Quality Index (BUREAU, 0–4 scale): -1.71 ([3.76]***).
  - Law and Order Index (LAWORDER, 0–6 scale): 0.13 ([0.56]).
  - FI × GOVSTAB: -0.19 ([1.59]).
  - FI × BUREAU: -1.94 ([2.38]**).
  - FI × LAWORDER: 0.10 ([0.31]).
- Interpretation:
  - Efficient bureaucracies (BUREAU) play a particularly significant role in avoiding fiscal loosening and in reinforcing adjustment when financial integration increases.
  - Other subindices (GOVSTAB, LAWORDER) show weaker or insignificant interactions with FI.

### Financial sector development
- Adding financial sector development (log private credit-to-GDP, FD) does not affect the significance of FI results.
- FD coefficients suggest that greater financial sector development may be associated with scope to loosen fiscal policy:
  - FD: 0.77 to 0.83 where reported ([1.77]* to [1.89]*).
- Interpretation: greater availability of domestic credit allows financing of larger fiscal deficits.

### Robustness: fiscal adjustment over different horizons (Table A3)
- Baseline specification reestimated with average change in fiscal deficit measured over 1, 2, 3, and 4 years.
- Key coefficients across horizons:
  - Central government deficit (DEF): -0.32 (1 year) [7.95]***; -0.28 (2 years) [10.69]***; -0.26 (3 years) [13.65]***; -0.25 (4 years) [16.50]***.
  - Index of institutional quality (INS): 15.89 (1 year) [4.42]***; 11.43 (2 years) [4.77]***; 9.52 (3 years) [5.02]***; 7.33 (4 years) [4.70]***.
  - Log financial integration (FI): -0.13 (1 year) [4.36]***; -0.10 (2 years) [4.99]***; -0.08 (3 years) [5.07]***; -0.07 (4 years) [4.82]***.
  - Log private credit-to-GDP (FD): 0.77 (1 year) [1.77]*; 0.47 (2 years) [1.73]*; 0.37 (3 years) [1.76]*; 0.28 (4 years) [1.62].
  - FI × DEF: -0.11 (1 year) [1.74]*; -0.11 (2 years) [2.86]***; -0.09 (3 years) [2.94]***; -0.07 (4 years) [2.85]***.
  - FI × INS: -0.19 (1 year) [4.54]***; -0.14 (2 years) [4.84]***; -0.11 (3 years) [5.10]***; -0.09 (4 years) [4.84]***.
- Observations and fit:
  - Observations: 436 (1 year), 421 (2 years), 391 (3 years), 362 (4 years).
  - Number of countries: 29 for all horizons.
  - R2: 0.31 (1 year), 0.44 (2 years), 0.57 (3 years), 0.67 (4 years).
- Conclusion: contributions of financial integration remain statistically significant at all four horizons, indicating persistent effects.

*Source: IMF staff estimates and source data as reported in the appendix.*

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