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Five Keys to a Smart Fiscal Policy

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We live in a world of dramatic economic change. Rapid technological innovation has fundamentally reshaped the way we live and work. International trade and finance, migration, and worldwide communications have made countries more interconnected than ever, exposing workers to greater competition from abroad. While these changes have brought tremendous benefits, they have also led to a growing perception of uncertainty and insecurity, particularly in advanced economies.

Today’s conditions require new, more innovative solutions, which the IMF calls smart fiscal policies. By smart policies we mean policies that facilitate change, harness its growth potential, and protect people who are hurt by it. At the same time, excessive borrowing and record levels of public debt have limited the financial resources available to government. So, fiscal policy must do more with less. Fortunately, researchers and policy makers are realizing that the fiscal tool kit is broader and the tools more powerful than they thought. Five guiding principles sketch the contours of these smart fiscal policies, which are described in chapter one of the IMF’s April 2017 Fiscal Monitor.


1.Fiscal policy should be countercyclical

Fiscal policy can be used to smooth the business cycle. That’s known as countercyclical policy. In bad times, taxes are lowered and spending is increased to put more money in the pockets of companies and consumers; in good times, spending is reduced and taxes raised. Fiscal policy has a greater role to play in economic stabilization today than in the past, because central banks in many advanced countries have cut interest rates very close to zero and the limits of monetary policy are being tested.

In normal circumstances, a countercyclical fiscal policy should rely on “automatic stabilizers,” that is, on spending and revenue that adjust to the ups and downs of the economy. Unemployment insurance is an example. In an economic downturn, people who lose their jobs are automatically eligible for government benefits. But these automatic stabilizers may not be sufficient in countries that are suffering from a protracted slump and where interest rates can’t go any lower, such as Japan. In such a situation, a temporary fiscal stimulus can break the downward spiral of low growth, low inflation, and high debt.

At the other end of the spectrum, economies with limited economic slack should, in general, withdraw fiscal support. For instance, the United States, which is close to full employment, could start reducing its budget deficit next year to put public debt firmly on a downward path.

Yet using fiscal policy to smooth the business cycle isn’t always feasible. Some countries may have to focus on reducing public deficits regardless of cyclical conditions. For instance, oil exporting countries, like Saudi Arabia, have been hit hard by a decline of more than 50 percent in the price of crude oil from the 2011 peak. These countries must reduce spending to bring it into line with lower revenue. They have already started to make the adjustment: their collective budget deficits are expected to fall by about $150 billion in 2017 and 2018.

2. Fiscal policy should be growth friendly

Tax and spending measures can be used to support the three engines of long-term economic growth: capital (such as machines, roads and computers), labor, and productivity (or how much each worker produces per hour).

3. Fiscal policy should promote inclusion

Globalization and technological change have been major drivers of growth and convergence between countries. More than one billion people have been lifted out of extreme poverty since the early 1980s, most of them in China and India. At the same time, income inequality has increased within many countries. In advanced economies, incomes of the top 1 percent have grown at annual rates almost three times higher than those of the rest of the population over the past three decades.

Taxes and public spending are powerful means to ensure that countries share the growth dividend among the population. For instance, conditional cash transfers (such as transfers to poor households that make benefits conditional on the attendance of children at health clinics and at school) have been used successfully to reduce inequality in a number of Latin America countries.

Fiscal policy should also help people fully participate in and adapt to a changing economy. Better access to education, training, and health services, as well as social insurance, can make it easier for workers to bounce back from a job loss or illness.


4. Fiscal policy should be supported by a strong tax capacity

How can policy makers achieve this ambitious agenda for fiscal policy when public debt is historically high? Where can they find the resources?

Governments need a strong capacity to tax in order to carry out the policies that we have described. Taxation provides a stable and adjustable source of revenue that can be mobilized if needed. It is also a central element in determining the ability of a country to repay its debt.

This is particularly important for low-income countries. It turns out that almost half of these countries have a ratio of tax-to-GDP that is below 15 percent. And interest payments often consume a large share of their tax revenue. In low-income countries, building tax capacity is a key priority for sustainable development.


5. Fiscal policy should be prudent

The global financial crisis showed that public finances are exposed to large risks that are often underestimated. Bailouts of failing banks and a deep economic slump drove public debt in advanced economies to levels unprecedented in peacetime.

Governments need to better understand the risks they are exposed to and adopt strategies to manage them. China provides an example of the importance of prudent fiscal policies. In China, debt has increased very fast in the past decade—faster than in any other major economy. The authorities recognize the need to tame the pace of debt accumulation and reduce financial risks. That is part of the overall process of rebalancing the growth model in China. Addressing these risks early on would improve the prospects for sustainable growth in the medium to long term. Fiscal policy, in China, can play an important role in facilitating the adjustment process. Important steps have been taken or are in train concerning public financial management and the relations among different levels of government.

Overall, fiscal policy is asked to do more with less. The Fiscal Monitor proposes five principles to guide the conduct of policy in this difficult environment. There is still room for more counter-cyclical, growth-friendly, inclusive, strong, and prudent fiscal policies around the world.