## _wp15124 — Annex II: Fiscal Anchors in Small States

## Source details

**Canonical URL:** [_wp15124 — Annex II: Fiscal Anchors in Small States](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15124.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15124.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15124.pdf.json)

---

### I. Introduction and Main Messages
- Distinctive fiscal management challenges in small developing states ("small states"):
  - Indivisibility in provision of public goods and public sector as main employer create rigidities and tilt spending toward recurrent outlays.
  - Greater revenue volatility than other country groups (IMF, 2013; Cabezon and others, 2013) driven by exposure to exogenous shocks and narrow production bases; particularly acute for fragile states and commodity exporters.
  - Limited capacity to finance temporary fiscal shocks because domestic banking systems are shallow and access to international capital markets is limited (Holden and Howell, 2009).
- Consequences:
  - High recurrent spending can crowd out capital spending, leading to underinvestment in infrastructure and growth-enhancing areas.
  - Budget frameworks are not typically multiyear, preventing smoothing of expenditures over the business cycle.
  - Revenue volatility has resulted in volatile spending patterns and procyclical fiscal policy, with budget pressures primarily affecting capital spending.
- Assessment challenges with headline balances:
  - Headline fiscal balances do not always reflect underlying fiscal positions because of revenue volatility, data deficiencies, capacity constraints, structural economic changes, extra-budgetary funds not integrated in budget presentation, and measurement difficulties for capital spending.
- Policy implication:
  - Strengthen fiscal frameworks by isolating the budget from revenue volatility and shielding public spending—especially capital—to increase resilience and boost potential growth.
  - Fiscal anchors should smooth revenue and capital expenditure over the business cycle, create policy space for infrastructure/health/education, strengthen medium-term orientation, and improve public financial management to raise spending quality.

### II. Improving the Mix of Public Spending
- Key findings on spending composition:
  - Current spending rigidity stems from a large share of current spending in GDP relative to other countries; small states face higher per capita government costs due to indivisibility of public goods and diseconomies of scale.
  - Relationship between country size and current spending is U-shaped; remoteness and dispersion raise costs.
  - Over the last ten years, capital spending in small states accounted for less than 20 percent of government spending—well below the average of low-income countries, which is 32 percent of government spending.
  - Exception: Cabo Verde embarked on a large investment program in the past decade, at the cost of recurrent spending.
- Econometric and event-analysis results:
  - Higher share of public investment for a given amount of public spending is associated with higher per capita growth (Appendix, Table 1).
  - Impact of capital spending on growth is stronger in small states than in other country groups; effect strongest in Asia and Pacific small states.
  - Increasing the share of capital investment will boost per capita growth, but expanding the deficit and increasing public debt beyond thresholds does not support growth.
  - Debt thresholds:
    - Asia and Pacific small states: 30 percent of GDP (debt threshold after which debt negatively affects growth).
    - Full sample: 50 percent of GDP.
  - Event analysis on government spending expansions:
    - Capital-led expansions produce a minimum increment in public-debt-to-GDP of about 2 percent.
    - Current-spending-led expansions see public-debt-to-GDP increase by about 10 percentage points of GDP.
    - Growth impact during and after capital-led episodes is higher than for current-led expansions.
  - Caveat: event analysis does not determine causality due to endogeneity; econometric GMM analysis addresses endogeneity (Appendix I, Table 1).
- Public spending efficiency:
  - Pacific small states show lower spending efficiency than other small developing states.
  - Large share of government spending in Pacific islands is allocated to health and education; outcomes remain relatively poor due to high costs of provision in small remote islands.
  - Positive relationship between population density and efficiency of public education and health expenditure (correlation coefficients: education 0.3; health 0.4).
  - Improving public financial management is needed to raise spending quality (Haque and others, 2012).

### III. Coping with Revenue Volatility
- Characteristics and sources:
  - Revenue volatility in small states is larger than in developing non-small states; revenue base is narrow and exposed to exogenous shocks.
  - Recent large drop in oil prices expected to continue contributing to revenue volatility.
  - Drivers include terms of trade shocks, volatility in trade flows (including tourism), remittances, natural disasters, and sector-specific factors (e.g., fishing license fees in Asia and Pacific small states).
- Quantified impacts:
  - A natural disaster affecting 1 percent of the population causes a drop in real revenue of 0.2 percentage point.
  - In Pacific small states, tax revenue contracts by 0.2 percentage point of GDP in the year of a disaster, followed by a rebound the next year (Appendix Figure 1).
- Heterogeneity across groups:
  - Highest revenue volatility among resource-rich countries (examples: Solomon Islands, Trinidad and Tobago, Guyana, Suriname) due to commodity price shocks and resource uncertainty.
  - Extremely high non-tax revenue volatility in APD microstates reliant on fishing license fees (Kiribati and Tuvalu where fees represent about 50 percent of revenues) and resource-rich countries (Timor-Leste, São Tomé and Príncipe, Bhutan) due to volatile royalties.
  - Elasticity of revenue to terms of trade (after controlling for GDP) is much higher in resource-rich small states than in comparators.
- Vulnerabilities and procyclicality:
  - Revenue volatility plus current spending rigidities and low access to finance have produced procyclical fiscal policy: spending tends to rise with revenues during upturns and fall with revenues during downturns.
  - Staff analysis indicates revenue shortages result in cuts to capital spending; econometric results confirm procyclicality of capital spending (Appendix Table 3).
- Fiscal anchors and buffer design recommendations:
  - Objective: build fiscal buffers for countercyclical support and create policy space for infrastructure.
  - Headline fiscal balances can mask underlying fiscal position; in a quarter of small states the improvement in underlying fiscal balance is smaller than the headline overall balance suggests.
  - Fiscal anchor plus an operational target:
    - Anchor: final objective to preserve sustainability (debt ratio is a natural anchor).
    - Operational target: intermediate target under government control and linked to debt dynamics.
  - Operational target options: revenue rule, expenditure rule, nominal balance, structural balance (level or first difference), or combinations.
  - Meaningful cyclically-adjusted balances are difficult to calculate due to erratic output gaps; underlying fiscal balance could be defined using a normal level of revenue (backward-looking averages) or, for commodity exporters, by removing direct and indirect commodity revenue effects.
  - Caveat: fiscal anchors are not a panacea; without strengthened fiscal institutions, moving away from a budget balance rule can create a deficit bias due to political pressures to spend windfalls during upturns.
  - Reforms should be supported by institutions that improve long-term revenue forecasts, quality public investment selection and implementation, and sound management of rainy-day funds.

### IV. Policy Reform Options
- Overarching objective:
  - Strengthen fiscal frameworks to sustain economic growth by balancing building fiscal buffers for rainy days and providing space for investment in infrastructure and human capital.
- Expected benefits:
  - Enhanced resilience by minimizing fiscal risks (especially in microstates).
  - Fiscal space for growth-enhancing and poverty-reducing investment.
  - Ability to use countercyclical spending during downturns.
  - Wise use of nonrenewable resource revenue in resource-rich small states to ensure long-term sustainability.
- Key challenges to address:
  - Budget rigidities, extreme revenue volatility, spending procyclicality, and limited capacity.
- Recommended comprehensive strategy pillars and measures:
  - Preserve strong fiscal fundamentals:
    - Over the cycle, deficits should be kept low, on average, to avoid accumulating rising debt burdens. Low deficits and moderate debt burdens are correlated with stronger GDP growth (page 6).
  - Minimize fiscal rigidity and lower recurrent spending to create fiscal space for capital spending:
    - Address wage bills, public servants’ benefits, and revenues earmarked for large capital projects.
    - Reform wage bill and public-sector entitlements; bolster revenue administration.
    - Deliver public goods at lowest possible recurrent cost; avoid supporting loss-making, inefficient public enterprises; consider outsourcing service delivery where possible.
  - Improve spending mix toward human and physical capital:
    - Use spending reviews and medium-term expenditure frameworks to reallocate resources toward priority spending (infrastructure including climate-proofing, health, education).
    - Improve business environment to attract private investors.
  - Adopt budget and investment practices to maximize returns on capital:
    - Strengthen project identification, prioritization, and implementation.
    - Adopt multiyear budget frameworks to clarify project financing and timing and to manage political-economy spending pressures and capacity constraints.
  - Identify resources to weather revenue volatility:
    - Use contingency funds within the budget, sovereign wealth funds for resource-rich economies, and/or insurance policies.
    - Natural disaster funds or general budget contingency reserves can save resources for disasters; access and reporting on these funds should be clearly defined and transparent (example: Solomon Islands’ National Transport Fund).
  - Use fiscal anchors to smooth spending and isolate budget from revenue volatility:
    - For resource-rich countries: target noncommodity fiscal balance and use sovereign wealth funds.
    - Budget should provide for spending in line with underlying revenues and distinguish temporary from sustained revenue shocks; sustained shocks may require spending adjustment with balanced recurrent/capital trade-offs.
  - Strengthen domestic revenue mobilization:
    - Bolster administration capacity and reform tax systems to increase fiscal space.
    - Tailor reforms to circumstances—for Pacific islands, focus on large taxpayers who account for 70–80 percent of revenue with a special unit, and use simplified tax systems/compliance for medium and small taxpayers.
    - Develop a proper mix of income and consumption taxation (VAT and sales tax).
    - Lower oil prices offer opportunity to reform energy subsidies and taxes; savings in oil-importing small states should strengthen fiscal buffers or increase public infrastructure where appropriate.
    - Example reforms: Kiribati introduced a withholding tax at source in March 2009 and introduced VAT in 2014.
  - Enhance regional cooperation on nontax revenue:
    - Strengthen regional economic, institutional, and technological networks (e.g., fisheries, ICT) to compensate for isolation and dispersion and to mobilize more revenues.
    - Nauru Agreement among eight Pacific island countries cited as success in mobilizing more fisheries revenues (IMF, 2014b).
- Institutional reforms:
  - Improve transparency (budget planning, internal auditing, monitoring, reporting, evaluation), cash management, and project management capacity.
  - Develop institutional frameworks to identify, quantify, monitor, and mitigate fiscal risks.
  - Integrate fiscal frameworks with debt management strategies to manage cash flows and reduce sovereign financing risks (example: Solomon Islands’ May 2012 debt management strategy that superseded the Honiara Club Agreement).
- IMF support:
  - IMF assistance includes capacity development through regional technical assistance centers (RTACs) and headquarters work (FAD) to reduce fiscal procyclicality, create fiscal space, and strengthen revenue and public financial management systems.

### Box 1 — Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers
- Policy trade-off:
  - Choice between building fiscal buffers for resilience (including natural disasters) and financing development spending (public investment).
  - Accumulating public savings instead of financing development spending implies forgoing the rate of return on the associated public investment; this foregone return is the opportunity cost of building fiscal buffers.
- Methodology:
  - Social return of public investment estimated as marginal productivity of capital.
  - Staff calibrated a Cobb-Douglas production function for Pacific Island economies using Penn World Table output and investment data and WEO data for 1970–2010.
  - Two measures of fiscal space estimated:
    - Fiscal Space 1: IMF/WBG DSA-based fiscal liquidity indicator expressed in percent of revenue.
    - Fiscal Space 2: Difference between actual debt, relative to GDP, and an estimated sustainable debt implied by each country’s historical record of fiscal adjustment (expressed in percent of GDP).
- Key findings:
  - Several Pacific islands have a high rate of return to capital, implying benefits from higher capital spending.
  - High social return to capital in the Pacific islands is broadly in line with returns observed in low-income countries.
  - A plot of the estimated opportunity cost of building buffers against the Human Development Index (HDI) suggests some Pacific islands stand to gain most from increasing budget shares devoted to capital spending.
  - Different fiscal-space measures provide similar ordering of countries in terms of size of fiscal space or opportunity costs of building buffers.
- Interpretation:
  - Where social return to capital is high, the opportunity cost of accumulating buffers is also high; this argues for greater priority on capital spending subject to debt sustainability and prudential considerations.
  - Convergence of rankings across fiscal-space measures increases confidence in cross-country comparisons.

### Selected Quantitative Findings and Key Statistics
- Capital spending in small states: less than 20 percent of government spending (last ten years).
- Low-income countries: capital spending is 32 percent of government spending (comparison).
- Debt threshold where debt negatively affects growth:
  - Asia and Pacific small states: 30 percent of GDP.
  - Full sample: 50 percent of GDP.
- Event-analysis public-debt-to-GDP changes during government expenditure expansions:
  - Capital-led expansions: public-debt-to-GDP increases by about 2 percent.
  - Current-led expansions: public-debt-to-GDP increases by about 10 percentage points of GDP.
- Natural disaster impact on revenue:
  - A natural disaster affecting 1 percent of population causes a drop in real revenue of 0.2 percentage point.
  - In Pacific small states: tax revenue contracts by 0.2 percentage point of GDP in disaster year, followed by rebound.
- Tax administration concentration:
  - Large taxpayers often account for 70–80 percent of revenue in many small states.
- Pacific small states Social Return of Capital and related figures (selected examples):
  - Fiji: Social Return of Capital 13.1; Average Interest Rate on Public Debt 7.2; Net 5.9
  - Kiribati: Social Return of Capital 14.8; Average Interest Rate on Public Debt 3.2; Net 11.6
  - Marshall Islands: Social Return of Capital 10.0; Average Interest Rate on Public Debt 1.4; Net 8.6
  - PICs memorandum: Social Return of Capital 12.2; Average Interest Rate on Public Debt 3.1; Net 9.1

### Annex — Fiscal Anchors and Funds (selected country excerpts)
- Palau:
  - Fiscal anchor: Law states that the current government balance should not observe a deficit.
  - Statutory base: International treaty
  - Compact Trust Fund: withdrawals specified in US$ amounts (US$5 million a year until 2013; increase gradually from US$5.25 million to US$13 million in 2023; from 2024 withdraw US$15 million a year); money to be used for education, health, justice, and public safety.
- Samoa:
  - Fiscal anchor: Net public debt at less than 50 percent of GDP. Fiscal deficit at not more than 3½ percent of GDP.
  - Statutory base: Political commitment
- Timor-Leste:
  - Fiscal anchor: Estimate Sustainable Income(ESI): 3 percent of total petroleum wealth (Petroleum Fund balance plus net present value of future revenues), with override.
  - Statutory base: Statutory (Petroleum Fund Law, 2005)
  - Petroleum Fund: funded with all oil revenue; withdrawals according to the ESI.
- Tonga:
  - Statutory base: Statutory (Public Finance Management Act 2002).
  - Tonga Trust Fund: set in 1988; assets were almost depleted to about US$3 million in 2002; assets described in the budget statement since 2012.
- Tuvalu:
  - Tuvalu Trust Fund: set in 1987; market value in excess of the maintained value (indexed to Australian CPI) is transferred to the Consolidated Investment Fund (CIF) where finance ministry can withdraw at its discretion.
- Vanuatu:
  - Fiscal anchor: General government debt below 40 percent of GDP. Ex ante balanced budget (refers to government operations excluding donors).
- Montenegro:
  - Fiscal anchor: Debt and deficit limits — Maastricht criteria: General Government gross debt less than 60 percent of GDP; General Government overall deficit less than 3 percent of GDP.
- Trinidad and Tobago:
  - Heritage and Stabilization Fund (HSF): Established in 2007 by legislation to save and invest energy revenue in excess of budgetary projections. Saving/withdrawal rule triggered when actual energy revenue exceeds (falls below) budgeted energy revenue by at least 10 percent. Minimum balance rule (capital floor) required no withdrawal should reduce HSF’s balance below US$1 billion at inception; raised to US$4 billion in 2014.
- Cross-cutting observations:
  - Common anchors include debt targets, deficit/balance rules, and saving/withdrawal rules tied to resource revenues (examples: ESI, HSF triggers).
  - Many countries rely on political commitment rather than legally binding statutory rules.
  - Several countries maintain stability funds or trust funds with widely varying operational features and withdrawal rules.

*Source: Annex II — Fiscal Anchors in Small States (IMF staff estimates and analysis).*

### References .............................................................................................................

### _wp15124 - References

### Tables
- 1.  Determinants of Real Per Capita GDP Growth ..................................................................22
- 2.  Determinants of Real Revenue ...........................................................................................23
- 3.  Degree of Spending Procyclicality .....................................................................................24

### Figures
- 1.  Small States: Spending Mix and Infrastructure Gap .............................................................5
- 2.  Measures of Efficiency of Public Spending and Population Dispersion ..............................7
- 3.  Health, Education Expenditure, and Selected Human Development Indicators ..................8
- 4.  Small States: Sources of Revenue Volatility ........................................................................9
- 5.  Small States: Revenue Volatility Across Different Groups ................................................11
- 6.  Small States: Procyclical Bias in Fiscal Policy ...................................................................12

### Boxes
- 1.  Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers ..................18
- 2.  From Best Practice to Best Fit: Lessons from Small States................................................20

### Appendix
- Econometric Analysis ..............................................................................................................22

### Annex I
- List of Small States ..................................................................................................................25

*Source: _wp15124 - References*

### Annex II

### Annex II — Fiscal Anchors in Small States

### I. Introduction and Main Messages
- Small developing states ("small states") face distinctive fiscal management challenges due to:
  - Indivisibility in provision of public goods and public sector as main employer, creating rigidities and tilting spending toward recurrent outlays.
  - Greater revenue volatility than other country groups (IMF, 2013; Cabezon and others, 2013), driven by exposure to exogenous shocks and narrow production bases; particularly acute for fragile states and commodity exporters.
  - Limited capacity to finance temporary fiscal shocks because domestic banking systems are shallow and access to international capital markets is limited (Holden and Howell, 2009).
- Consequences of these features:
  - High recurrent spending can crowd out capital spending, leading to underinvestment in infrastructure and growth-enhancing areas.
  - Budget frameworks are not typically multiyear, preventing smoothing of expenditures over the business cycle.
  - Revenue volatility has resulted in volatile spending patterns and procyclical fiscal policy, with budget pressures primarily affecting capital spending.
- Assessment challenges:
  - Headline fiscal balances do not always reflect underlying fiscal positions because of revenue volatility (notably in the Pacific), data deficiencies, capacity constraints, structural economic changes, extra-budgetary funds not integrated in budget presentation, and measurement difficulties for capital spending.
- Policy implication:
  - Strengthening fiscal frameworks by isolating the budget from revenue volatility and shielding public spending—especially capital—could increase resilience and boost potential growth.
  - Fiscal anchors should smooth revenue and capital expenditure over the business cycle, create policy space for infrastructure/health/education, strengthen medium-term orientation (move away from year-by-year formulation), and improve public financial management to raise spending quality.

### II. Improving the Mix of Public Spending
- Key findings on spending composition:
  - Current spending rigidity stems from a large share of current spending in GDP relative to other countries; small states face higher per capita government costs due to indivisibility of public goods and diseconomies of scale.
  - The relationship between country size and current spending is U-shaped; distance from key markets raises import transportation costs; microstates and Pacific islands face compounded challenges from remoteness and dispersion.
  - Over the last ten years, capital spending in small states accounted for less than 20 percent of government spending—well below the average of low-income countries, which is 32 percent of government spending.
  - Exception: Cabo Verde embarked on a large investment program in the past decade, at the cost of recurrent spending.
- Econometric and event-analysis results:
  - Higher share of public investment for a given amount of public spending is associated with higher per capita growth (Appendix, Table 1).
  - Impact of capital spending on growth is stronger in small states than in other country groups; effect strongest in Asia and Pacific small states.
  - Increasing the share of capital investment will boost per capita growth, but expanding the deficit and increasing public debt beyond thresholds does not support growth.
  - Thresholds: For Asia and Pacific small states, the debt threshold after which debt negatively affects growth is 30 percent of GDP—below the 50 percent threshold for the full sample.
  - Event analysis: government spending expansions led by capital result in higher real GDP per capita and lower public-debt-to-GDP increases than expansions led by current spending:
    - Capital-led expansions produce a minimum increment in public-debt-to-GDP of about 2 percent.
    - Current-spending-led expansions see public-debt-to-GDP increase by about 10 percentage points of GDP.
    - Growth impact during and after capital-led episodes is higher than for current-led expansions.
  - Caveat: event analysis does not determine causality due to endogeneity; econometric GMM analysis addresses endogeneity (Appendix I, Table 1).
- Public spending efficiency:
  - Pacific small states show lower spending efficiency than other small developing states.
  - A large share of government spending in Pacific islands is allocated to health and education; outcomes remain relatively poor due to high costs of provision in small remote islands.
  - Positive relationship observed between population density and efficiency of public education and health expenditure (correlation coefficients: education 0.3; health 0.4).
  - Improving public financial management is needed to raise spending quality (Haque and others, 2012).

### III. Coping with Revenue Volatility
- Revenue volatility characteristics:
  - Revenue volatility in small states is larger than in developing non-small states; revenue base is narrow and exposed to exogenous shocks.
  - Recent large drop in oil prices expected to continue contributing to revenue volatility.
- Sources of volatility and heterogeneity:
  - Revenue exhibits strong procyclicality, especially in net commodity importers.
  - Terms of trade shocks, volatility in trade flows (including tourism), remittances, natural disasters, and sector-specific factors (e.g., fishing license fees in Asia and Pacific small states) drive revenue volatility.
  - Staff analysis: a natural disaster affecting 1 percent of the population causes a drop in real revenue of 0.2 percentage point.
  - In Pacific small states, tax revenue contracts by 0.2 percentage point of GDP in the year of a disaster, followed by a rebound the next year (Appendix Figure 1).
  - Elasticity of revenue to terms of trade (after controlling for GDP) is much higher in resource-rich small states than in comparators.
- Degree of volatility across groups:
  - Highest revenue volatility among resource-rich countries (e.g., Solomon Islands, Trinidad and Tobago, Guyana, Suriname) due to commodity price shocks and resource uncertainty.
  - Extremely high non-tax revenue volatility in APD microstates reliant on fishing license fees (e.g., Kiribati and Tuvalu where fees represent about 50 percent of revenues) and resource-rich countries (Timor-Leste, São Tomé and Príncipe, Bhutan) due to volatile royalties.
- Vulnerabilities and procyclicality:
  - High revenue volatility can cause output volatility and undermine fiscal performance absent stabilization funds (IMF, 2012).
  - Revenue volatility plus current spending rigidities and low access to finance have produced procyclical fiscal policy: spending tends to rise with revenues during upturns and fall with revenues during downturns.
  - Staff analysis indicates revenue shortages result in cuts to capital spending; econometric results confirm procyclicality of capital spending (Appendix Table 3).
- Fiscal anchors and buffers:
  - Building fiscal buffers for countercyclical support and creating policy space for infrastructure are key to resilience.
  - Headline fiscal balances can mask the underlying fiscal position; in a quarter of small states the improvement in underlying fiscal balance is smaller than the headline overall balance suggests.
  - Design recommendations:
    - Fiscal anchor plus an operational target: the anchor is the final objective to preserve sustainability (debt ratio is a natural anchor), while the operational target is an intermediate target under government control and linked to debt dynamics.
    - Options for operational targets include revenue rule, expenditure rule, nominal balance, structural balance (level or first difference), or combinations.
    - Meaningful cyclically-adjusted balances are difficult to calculate due to erratic output gaps driven by external developments; underlying fiscal balance could be defined using a normal level of revenue (backward-looking averages) or, for commodity exporters, by removing direct and indirect commodity revenue effects.
  - Caveat: fiscal anchors are not a panacea; without strengthened fiscal institutions, moving away from a budget balance rule can create a deficit bias due to political pressures to spend windfalls during upturns.
  - Reforms should be supported by institutions that improve long-term revenue forecasts, quality public investment selection and implementation, and sound management of rainy-day funds.

### IV. Policy Reform Options
- Overarching objective:
  - Strengthen fiscal frameworks to sustain economic growth by balancing building fiscal buffers for rainy days and providing space for investment in infrastructure and human capital.
- Benefits of strengthening fiscal frameworks:
  - Enhanced resilience by minimizing fiscal risks (especially in microstates).
  - Fiscal space for growth-enhancing and poverty-reducing investment.
  - Ability to use countercyclical spending during downturns.
  - Wise use of nonrenewable resource revenue in resource-rich small states to ensure long-term sustainability.
- Challenges:
  - Budget rigidities, extreme revenue volatility, spending procyclicality, and limited capacity.
- Recommended comprehensive strategy pillars:
  - Preserving strong fiscal fundamentals:
    - Over the cycle, deficits should be kept low, on average, to avoid accumulating rising debt burdens. Low deficits and moderate debt burdens are correlated with stronger GDP growth (page 6).
  - Minimizing fiscal rigidity and lowering recurrent spending to create fiscal space for capital spending:
    - Address wage bills, public servants’ benefits, and revenues earmarked for large capital projects.
    - Reform wage bill and public-sector entitlements; bolster revenue administration.
    - Deliver public goods at lowest possible recurrent cost and avoid supporting loss-making, inefficient public enterprises; consider outsourcing service delivery to the private sector where possible.
  - Improving spending mix toward human and physical capital:
    - Use spending reviews and medium-term expenditure frameworks to reallocate resources toward priority spending (infrastructure including climate-proofing, health, education).
    - Improve business environment to attract private investors.
  - Adopting budget and investment practices to maximize returns on capital:
    - Strengthen project identification, prioritization, and implementation.
    - Adopt multiyear budget frameworks to clarify project financing and timing and to manage political-economy spending pressures and capacity constraints.
  - Identifying resources to weather revenue volatility:
    - Use contingency funds within the budget, sovereign wealth funds for resource-rich economies, and/or insurance policies.
    - Natural disaster funds or general budget contingency reserves can save resources for disasters; access and reporting on these funds should be clearly defined and transparent (example: Solomon Islands’ National Transport Fund).
  - Using fiscal anchors to smooth spending and isolate budget from revenue volatility:
    - For resource-rich countries: target noncommodity fiscal balance and use sovereign wealth funds.
    - Budget should provide for spending in line with underlying revenues and distinguish temporary from sustained revenue shocks; sustained shocks may require spending adjustment with balanced recurrent/capital trade-offs.
  - Strengthening domestic revenue mobilization:
    - Bolster administration capacity and reform tax systems to increase fiscal space.
    - Tailor reforms to circumstances—for Pacific islands, focus on large taxpayers who account for 70–80 percent of revenue with a special unit, and use simplified tax systems/compliance for medium and small taxpayers.
    - Develop a proper mix of income and consumption taxation (VAT and sales tax).
    - Lower oil prices offer opportunity to reform energy subsidies and taxes; savings in oil-importing small states should strengthen fiscal buffers or increase public infrastructure where appropriate.
    - Example: Kiribati improved tax collection with a withholding tax at source in March 2009 and introduced VAT in 2014.
  - Enhancing regional cooperation on nontax revenue:
    - Strengthen regional economic, institutional, and technological networks (e.g., fisheries, ICT) to compensate for isolation and dispersion and to mobilize more revenues.
    - The Nauru Agreement among eight Pacific island countries is cited as a success in mobilizing more fisheries revenues (IMF, 2014b).
- Institutional reforms:
  - Improve transparency (budget planning, internal auditing, monitoring, reporting, evaluation), cash management, and project management capacity.
  - Develop institutional frameworks to identify, quantify, monitor, and mitigate fiscal risks.
  - Integrate fiscal frameworks with debt management strategies to manage cash flows and reduce sovereign financing risks (example: Solomon Islands’ May 2012 debt management strategy that superseded the Honiara Club Agreement).
- IMF support:
  - IMF assistance includes capacity development through regional technical assistance centers (RTACs) and headquarters work (FAD) to reduce fiscal procyclicality, create fiscal space, and strengthen revenue and public financial management systems.

### Selected Quantitative Findings and Key Statistics
- Capital spending in small states: less than 20 percent of government spending (last ten years).
- Low-income countries: capital spending is 32 percent of government spending (comparison).
- Debt threshold where debt negatively affects growth:
  - Asia and Pacific small states: 30 percent of GDP.
  - Full sample: 50 percent of GDP.
- Event-analysis public-debt-to-GDP changes during government expenditure expansions:
  - Capital-led expansions: public-debt-to-GDP increases by about 2 percent.
  - Current-led expansions: public-debt-to-GDP increases by about 10 percentage points of GDP.
- Natural disaster impact on revenue:
  - A natural disaster affecting 1 percent of population causes a drop in real revenue of 0.2 percentage point.
  - In Pacific small states: tax revenue contracts by 0.2 percentage point of GDP in disaster year, followed by rebound.
- Tax administration concentration:
  - Large taxpayers often account for 70–80 percent of revenue in many small states.
- Pacific small states Social Return of Capital and related figures (selected examples):
  - Fiji: Social Return of Capital 13.1; Average Interest Rate on Public Debt 7.2; Net 5.9
  - Kiribati: Social Return of Capital 14.8; Average Interest Rate on Public Debt 3.2; Net 11.6
  - Marshall Islands: Social Return of Capital 10.0; Average Interest Rate on Public Debt 1.4; Net 8.6
  - PICs (Pacific Island Countries) memorandum: Social Return of Capital 12.2; Average Interest Rate on Public Debt 3.1; Net 9.1
- Opportunity cost example (Pacific Islands):
  - PICs: marginal product of capital estimates plotted versus HDI (figure), showing trade-offs between building fiscal buffers and public investment returns.

*Source: Annex II, "Fiscal Anchors in Small States" (IMF staff estimates and analysis).*

### Box 1. Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers

### Box 1. Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers

### Policy trade-off
- Policymakers in small developing states face a choice between:  
  - building fiscal buffers to enhance resilience to shocks—including natural disasters; and  
  - financing development spending (public investment).  
- Accumulating public savings (fiscal buffers) instead of financing development spending implies forgoing the rate of return on the associated public investment; this foregone return is the opportunity cost of building fiscal buffers and can inform the optimal mix between buffers and capital spending.

### Methodology
- Social return of public investment is estimated by assuming it equals the marginal productivity of capital.  
- Following Caselli and Feyrer (2007), staff calibrated a Cobb-Douglas production function for a group of Pacific Island economies using:  
  - data on output and investment from the Penn World Table; and  
  - WEO data for the period 1970–2010.  
- Two measures of fiscal space were estimated:  
  - Fiscal Space 1: an IMF/WBG DSA-based fiscal liquidity indicator derived by measuring the average gap over the medium term between the debt-service-to-revenue ratio of public and publicly guaranteed debt and an indicative threshold after which the debt becomes unsustainable (expressed in percent of revenue).  
  - Fiscal Space 2: the difference between actual debt, relative to GDP, and an estimated sustainable debt (á la Ostry and others, 2010) implied by each country’s historical record of fiscal adjustment (expressed in percent of GDP).

### Key findings
- Several Pacific islands enjoy a high rate of return to capital, implying that they would benefit from higher capital spending.  
- High social return to capital in the Pacific islands is broadly in line with returns observed in low-income countries.  
- A plot of the estimated opportunity cost of building buffers against the Human Development Index (HDI)—used as a proxy for infrastructure needs—suggests that some Pacific islands stand to gain the most from increasing the share of their budget devoted to capital spending.  
- When plotting the three different measures of fiscal space against the HDI, the different measures provide similar ordering of countries in terms of the size of fiscal space or the opportunity costs of building buffers.

### Interpretation and implications
- Where the social return to capital is high (as found for several Pacific islands), the opportunity cost of accumulating fiscal buffers is also high; this argues for greater priority on capital spending in those countries, subject to debt sustainability and prudential considerations.  
- Convergence of rankings across distinct fiscal-space measures increases confidence in cross-country comparisons of where the opportunity cost of buffers is greatest.  
- Using HDI as a proxy for infrastructure needs helps identify countries where reallocating budget shares toward capital spending could yield larger social returns.

*Source: IMF staff estimates (Box 1, “Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers”).*

### Annex II Fiscal Anchors in Small States

### Annex II Fiscal Anchors in Small States

### Pacific (APD) — Country fiscal anchors, statutory basis, and funds
- Palau
  - Fiscal anchor: Law states that the current government balance should not observe a deficit.
  - Statutory base: International treaty
  - Stability Fund/Trust Fund: Compact Trust Fund: Since 1994 to replace grants income. The government can withdraw US$5 million a year until 2013 and then increase gradually from US$5.25 million to US$13 million in 2023. From 2024 it can withdraw US$15 million a year. The money should be used for education, health, justice, and public safety.
- Samoa
  - Fiscal anchor: Net public debt at less than 50 percent of GDP. Fiscal deficit at not more than 3½ percent of GDP.
  - Comment: The government aims to reduce public debt to 50 percent of GDP by 2019/20 and the fiscal deficit to 2 percent of GDP over the medium term.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- Solomon Islands
  - Fiscal anchor: Budget balance rule.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: Contingency fund
- Timor-Leste
  - Fiscal anchor: Estimate Sustainable Income(ESI): 3 percent of total petroleum wealth (Petroleum Fund balance plus net present value of future revenues), with override.
  - Comment: Excess withdrawals (with parliamentary approval) have been used on a temporary basis to finance development projects.
  - Statutory base: Statutory (Petroleum Fund Law, 2005)
  - Stability Fund/Trust Fund: Petroleum Fund: Set up in 2005 with IMF advice to smooth oil revenue. It is funded with all oil revenue. Withdrawals are according to the ESI.
- Tonga
  - Fiscal anchor: No specific fiscal anchor, but adopted three-year budget framework.
  - Statutory base: Statutory (Public Finance Management Act 2002).
  - Stability Fund/Trust Fund: Tonga Trust Fund: Set in 1988 to reserve funds for exceptional circumstances and for future major development projects. However, assets were almost depleted to about US$3 million in 2002 owing to the absence of transparency and accountability of its management and operation. Assets described in the budget statement since 2012.
- Tuvalu
  - Fiscal anchor: NA
  - Statutory base: NA
  - Stability Fund/Trust Fund: Tuvalu Trust Fund: Set in 1987 to provide additional funding for budget support. Market value in excess of the maintained value, which is indexed to the Australian CPI, is transferred to the Consolidated Investment Fund (CIF) where the finance ministry can withdraw at its discretion.
- Vanuatu
  - Fiscal anchor: General government debt below 40 percent of GDP. Ex ante balanced budget.
  - Comment: The balanced budget refers to the government’s operations excluding donors.
  - Statutory base: No
  - Stability Fund/Trust Fund: fund: No fund

### Europe (EUR)
- Montenegro
  - Fiscal anchor: Debt and deficit limits — Maastricht criteria: General Government gross debt less than 60 percent of GDP; General Government overall deficit less than 3 percent of GDP, but enforcement mechanism is weak.
  - Statutory base: Statutory (Legislation, the fiscal rule was approved in 2014.)
  - Stability Fund/Trust Fund: No fund

### Western Hemisphere & Caribbean/Latin America (WHD) — country anchors, targets, and funds
- Antigua and Barbuda
  - Fiscal anchor: Debt target
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- The Bahamas
  - Fiscal anchor: Fiscal balance target/debt target — Target to reduce government debt to 58.5 percent of GDP by FY 2016/17.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- Barbados
  - Fiscal anchor: Central government balance target — Target to achieve the central government deficit of 6.6 percent of GDP in FY 2014/15 (excludes balance of public enterprises, which have incurred growing deficits and continue to pose large fiscal risks).
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- Belize
  - Fiscal anchor: Fiscal balance target, debt target — Belize has adopted an indicative target of 60-65 percent of GDP. It maintains an annual primary balance target of 1 percent of GDP. Reversed in 2012/13 from a previously announced target of 2 percent of GDP.
  - Statutory base: Political commitment. No specific measures to achieve debt target.
  - Stability Fund/Trust Fund: No fund
- Dominica
  - Fiscal anchor: Debt target — Dominica has its own target of a primary surplus of 2.4 percent of GDP to be achieved over the cycle.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- Grenada
  - Fiscal anchor: Debt target, expenditure rule (proposed) — Under an ECF arrangement, approved in June 2014, fiscal adjustment is anchored by a primary surplus of 3.5 percent of GDP, to be achieved by 2016. Soon-to-be-approved Fiscal Responsibility legislation proposes an expenditure rule to limit growth of real central government expenditures to 2 percent a year.
  - Comment: The debt target is supported by political commitment. The proposed expenditure rule will be backed by legislation.
  - Stability Fund/Trust Fund: No fund
- Guyana
  - Fiscal anchor: Debt target — Debt-to-GDP ratio less than 40 percent in NPV terms. Target is embedded in the medium-term framework of the authorities.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- St. Kitts and Nevis
  - Fiscal anchor: Debt target — With stronger growth and ample revenues, it would appear that this target will be achieved more quickly, and the staff plans to propose that zero primary balance become the new fiscal anchor.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: Sugar Industry Diversification Foundation: Set in 2006 as an independent foundation, funded by Citizenship-By-Investment Program. Its mandate was expanded in 2011 to support the government’s efforts to diversify the economy and maintain economic stability.
- St. Lucia
  - Fiscal anchor: Debt target
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- St. Vincent and the Grenadines
  - Fiscal anchor: Debt target
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: No fund
- Suriname
  - Fiscal anchor: Debt rule — Public debt ceiling of 60 percent of GDP of which domestic debt ceiling of 25 percent and external debt ceiling of 35 percent.
  - Statutory base: Statutory
  - Stability Fund/Trust Fund: No fund
- Trinidad and Tobago
  - Fiscal anchor: Fiscal balance target — Improve overall fiscal balance by a minimum of 1 percent of GDP annually starting FY2013/14 to achieve a balanced budget by 2016/17. However, specific policies to achieve the target were not specified.
  - Statutory base: Political commitment
  - Stability Fund/Trust Fund: Heritage and Stabilization Fund (HSF): Established in 2007 by legislation to save and invest energy revenue in excess of budgetary projections. The saving (withdrawal) rule is triggered when actual energy revenue exceeds (falls below) budgeted energy revenue by at least 10 percent. There is also a minimum balance rule (capital floor), requiring that no withdrawal should reduce the HSF’s balance below US$1 billion at inception, but it was raised to US$4 billion in 2014.

### Cross-cutting observations from the annex table
- Common fiscal anchors include debt targets, deficit/balance rules, and specific saving/withdrawal rules tied to resource revenues (e.g., ESI or HSF triggers).
- Many countries rely on political commitment rather than legally binding statutory rules.
- Several countries maintain stability funds or trust funds designed to smooth revenue volatility or provide budget support; operational features and withdrawal rules vary widely (examples: Compact Trust Fund, Petroleum Fund, Tonga Trust Fund, Tuvalu Trust Fund, Heritage and Stabilization Fund).
- Numeric thresholds and targets preserved exactly as reported above (examples: net public debt less than 50 percent of GDP; fiscal deficit not more than 3½ percent of GDP; ESI: 3 percent; debt ceilings of 60 percent, 25 percent, 35 percent; targets such as 58.5 percent of GDP, US$1 billion, US$4 billion, US$5 million, US$15 million).

*Source: Annex II Fiscal Anchors in Small States (IMF).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15124.pdf_