The Case for Fiscal Policy to Support Structural Reforms

IMF Blog, March 13, 2017

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Authors: Angana Banerji, Era Dabla‑Norris, Romain Duval, Davide Furceri
Publication date: March 13, 2017
Purpose: Present new empirical and model-based research on how fiscal policy (spending or tax incentives) can help implement labor and product market structural reforms, particularly in the early stages, when reforms face short-term costs and political opposition.

Research sample: past labor and product market reforms in 26 advanced economies; detailed case studies of Finland, Germany, Ireland, the Netherlands, and the United Kingdom.
Impact on GDP: labor and product market reforms generally increase GDP—up to 2-3 percent over the medium term, depending on the type of reform—by boosting productivity or employment.
Effect on public finances:
- Higher GDP brings in more tax revenues.
- Both higher GDP and increased tax revenues reduce public debt-to-GDP ratios over time.
- Implementing reforms will therefore help cash-strapped governments.
Historical example: past product market deregulation in the mid-1990s in several network industries in Germany (telecommunications and energy) improved public finances.

Some reforms can temporarily reduce rather than increase GDP (for example, reducing employment protection for regular workers or cutting unemployment benefits when the economy is weak), which can damage public finances in the short term.
Temporary fiscal support—spending on high-return projects or tax incentives—can make reforms work more effectively in countries that can afford it, producing fiscal gains over the medium term when reform-driven output improvements occur.
Risk of counterproductive outcomes in fiscally constrained countries unless incentives are budget neutral.

Finland, Germany, and the United Kingdom: reduced tax burden for people with low incomes while combining cuts in personal income tax rates with reforms in unemployment benefits and other social safety nets to help those affected—implemented without increasing the budget deficit.
Germany, Ireland, and the United Kingdom: combined incentives for product market reforms with reforms that reduced government spending (for example, cutting corporate taxes while reducing government subsidies that benefitted industry).
Ireland: occasional fiscal sweeteners (example cited: a tax write-off of capital losses from the deregulation of the taxi industry), but only after reforms were implemented.
Trade-off noted: efforts to reduce government debt and deficits while providing incentives for reform sometimes led to harmful cuts in infrastructure investment.

Preconditions for using fiscal support:
- Countries need sustainable fiscal positions, a robust medium-term fiscal framework, and a credible commitment to major reforms.
- Countries must be able to afford temporary spending or tax incentives.
For countries with fiscal room:
- Use temporary immediate support for reforms—particularly labor market reforms—when the economy is weak.
- Target spending on high-return projects or tax incentives to help those most affected and to build political support.
For countries without money to spare:
- Push forward with labor and product market reforms, prioritizing those with lower near-term costs.
- Provide help in a budget neutral way as part of a broader reform package.
- Design reforms in smart, phased ways (example: pass job legislation reforms that come into force with a one- or two-year delay to encourage near-term investment and hiring while avoiding layoffs).
Overarching requirement: the case for providing fiscal support at the start of reforms rests crucially on the credibility of the government’s commitment to strong implementation of comprehensive reforms and sustainable fiscal policies.

Source: The Case for Fiscal Policy to Support Structural Reforms, IMF blog entry, March 13, 2017.