The Times They are a-Changin’: will (fiscal) history repeat itself?

IMF Blog, July 24, 2013

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Simple empirical evidence suggests convergence of real per capita GDP in emerging markets to the level observed in Western Europe and the United States in the early sixties.
Conjecture: once per capita income achieves this level, the rise of the middle class prompts demands for more equity in the distribution of economic and political power.
Historical analogy: the 1960s in advanced economies—rise of the middle class → wave of social unrest and change → calls for more social justice, more democracy, and a better life → deep social and economic transformations.
Scenario proposed: the 2010s could be for emerging economies what the 1960s were for advanced ones—a wonderful decade accompanied by major economic, social, and fiscal challenges.

Observed pattern in western countries: the rise of the welfare state (particularly increased spending for pension and health care) matched demands for social justice with a surge in public spending.
Exact magnitude: the ratio between public spending and GDP increased by about 20 percentage points between the early 1960s and the early 1980s, essentially stabilizing since then.
Financing path:
- Initially financed by increased revenues while growth remained strong.
- From the early 1970s, deficit financing became the dominant mode.
- Result: a surge in the public debt-to-GDP ratio that lasted throughout the early 1990s.
- Increases in tax rates—an increased mobilization of internal resources—eventually contained the rise in deficit and debt.
Constraint observed post-2008: the trend increase in debt in advanced economies limited the possibility of supporting economic activity after the 2008–09 crisis, forcing governments to exit early from supportive fiscal policy.

Key risks if emerging economies replicate spending surges:
- Strong pressure to finance increased spending through increased debt accumulation.
- Greater vulnerability to an increase in interest rates.
- Reduced fiscal space to respond to unforeseen shocks.
- Risk that once taxes reach a certain level they distort economic incentives and harm underlying growth potential.
Uncertainties:
- The tax level at which distortion occurs is unknown and likely differs across countries due to economic and cultural factors.
Policy implication:
- Emerging markets would have to manage potential surges in public spending carefully to avoid unsustainable debt dynamics and preserve growth.

"early sixties"
"early 1960s"
"early 1980s"
"early 1970s"
"2008–09 crisis"
"early 1990s"
Increase in the ratio between public spending and GDP: "about 20 percentage points"
Decadal comparison: "the 2010s will be for emerging economies what the 1960s were for advanced ones"
Per-capita income caption: "The average level of per capita income of emerging economies has now reached, in PPP real terms, approximately the level reached by advanced economies in the early sixties."

Carlo Cottarelli, July 24, 2013.