Ten Commandments for Fiscal Adjustment in Advanced Economies

IMF Blog, June 24, 2010

Source details

Commandment I: You shall have a credible medium-term fiscal plan with a visible anchor (in terms of either an average pace of adjustment, or of a fiscal target to be achieved within four–five years).
- Recommendation: An average improvement in the cyclically-adjusted primary balance of some 1 percentage point per year during the next four–five years would be consistent with gradually closing the output gap and stabilizing the average debt ratio by the middle of this decade.
- Caveat: Countries with higher deficits/debt should do more, others should do less. Pace must be backed by fairly specific spending and revenue projections and supported by structural reforms.

Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it.
- Recommendation: A steady pace of adjustment is generally preferable to front-loading, which could undermine the recovery and be reversed.
- Note: A non-trivial first installment is needed; current consolidation plans in advanced G-20 countries imply on average a reduction in the cyclically adjusted deficit of some 1¼ percentage point of GDP in 2011, with significant dispersion across countries.
- Implementation detail: Front-loading approval of policy measures that become effective later enhances credibility.

Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilization at post-crisis levels.
- Finding: In the G-7 average, gross debt was 82 percent of GDP in 2007, a level never reached before without a major war.
- Rationale: High public debt tends to raise interest rates, lower potential growth, and impede fiscal flexibility; the final goal must be to lower public debt ratios gradually but steadily.

Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth.
- Recommendation: Bias towards current spending cuts because spending ratios are high and tax levels are distortionary.
- Examples: Shift from universal to targeted social transfers; contain public sector wages.
- Caveat: Nothing should be ruled out—countries with low revenue ratios and large adjustment needs will also have to act on the revenue side.

Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable.
- Finding: Increases in pension and health care spending represented over 80 percent of the increase in primary public spending to GDP ratio observed in the G-7 countries in the last decades.
- Finding: The net present value of future increases in health care and pension spending is more than ten times larger than the increase in public debt due to the crisis.
- Recommendation: Early action in these areas increases credibility more than fiscal front-loading and may have positive effects on demand and supply (for example, committing to an increase in the retirement age over time).

Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable.
- Dimensions: Maintain adequate social safety nets and public services; fight tax evasion.
- Fact: For VAT, tax evasion averages about 15 percent of revenues in G-20 advanced countries. Evasion for other taxes is likely to be higher.

Commandment VII: You shall implement wide reforms to boost potential growth.
- Quantified effect: A one percentage point increase in potential growth—assuming a tax ratio of 40 percent—lowers the debt ratio by 10 percentage points within 5 years and by 30 percentage points within 10 years, if the resulting higher revenues are saved.
- Recommendation: Accelerate labor, product and financial market reforms.
- Policy preference: In a context of weak aggregate demand, reforms that increase investment are more desirable than reforms that increase saving.
- Caution: Timing and magnitude of structural reform effects on growth are uncertain; plans relying on faster growth would not be credible.

Commandment VIII: You shall strengthen your fiscal institutions.
- Finding: Current institutions allowed record public debt accumulation before the crisis and are insufficient.
- Recommendations: Better fiscal rules (including in Europe); better budgetary processes (including in the United States); better fiscal monitoring, including independent fiscal agencies.

Commandment IX: You shall properly coordinate monetary and fiscal policy.
- Recommendation: If fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of recovery.
- Judgment: Calls for an early monetary policy tightening in advanced economies are misplaced.

Commandment X: You shall coordinate your policies with other countries.
- Issue: In many advanced countries, reduction in budget deficits must come with a reduction in current account deficits; to maintain recovery, initial adverse effects of fiscal consolidation on internal demand must be offset by stronger external demand.
- Recommendation for emerging markets: Some emerging market economies with current account surpluses must shift from external to internal demand; recent decisions taken by China are cited as an important step.
- Additional point: Policy coordination will be important to protect fiscal revenues from rising tax competition.

Average improvement suggested: some 1 percentage point per year in the cyclically-adjusted primary balance during the next four–five years.
Current consolidation plans: on average a reduction in the cyclically adjusted deficit of some 1¼ percentage point of GDP in 2011 for advanced G-20 countries.
G-7 gross debt: 82 percent of GDP in 2007.
Contribution of pensions and health care: over 80 percent of the increase in primary public spending to GDP ratio in the G-7 over recent decades.
Net present value of future pension and health care increases: more than ten times larger than the increase in public debt due to the crisis.
VAT evasion: about 15 percent of revenues in G-20 advanced countries.
Growth effect on debt: one percentage point increase in potential growth lowers debt by 10 percentage points within 5 years and by 30 percentage points within 10 years, assuming a tax ratio of 40 percent and that higher revenues are saved.

Source: Ten Commandments for Fiscal Adjustment in Advanced Economies, Olivier Blanchard and Carlo Cottarelli, June 24, 2010.