Fiscal Institutions and the Pandemic
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- Authors: Felipe Larrain Bascunan
- Published: March 1, 2022
Role of fiscal institutions in pandemic response
- Fiscal institutions are crucial for every country, and especially for those that are resource-intensive.
- Countries with responsible fiscal conduct before COVID-19 were better able to strengthen health systems and deliver fiscal transfers, subsidies, and guarantees, allowing faster recovery.
- Aggressive fiscal responses to the pandemic had positive effects on stock markets, currencies, industrial production, employment, confidence, and sovereign risk premiums (Deb and others 2021).
- Many advanced economies and those with lower public debt experienced greater effects from fiscal measures.
- Most countries that had fiscal space or sovereign wealth funds were able to use these to address economic and social effects of the pandemic.
- The poorest countries in Africa, the Americas, and Asia bolstered spending or forgone revenue by less than 2.5 percent of GDP, implying a slower and more uneven recovery with significant negative impacts on output and income distribution.
Chile as an illustrative example
- Chile, described as the world’s 43rd largest economy, with a sound fiscal policy framework, responded to the pandemic on roughly the same scale as some of the world’s richest nations—Germany, Japan, the United Kingdom, and the United States—by increasing outlays or forgoing revenue by more than 10 percent of GDP.
- In the absence of an institutional framework, government spending is typically bound by current-year public resources (mainly tax revenue) and limited borrowing capacity, which can exacerbate economic cycles because fiscal revenues tend to be procyclical.
- For resource-intensive countries, where commodity exports typically account for over 60 percent—and in some cases more than 90 percent—of total exports, fiscal revenues depend heavily on commodity prices, increasing the importance of an institutional fiscal framework.
Recommended fiscal framework components (three pillars)
- Fiscal rule:
- A long-term vision that isolates public spending from cyclical fluctuations.
- Example approach: annual fiscal balance targets based on the country’s capacity to generate long-term or structural revenues rather than on current revenues.
- When actual income exceeds long-term levels during a boom, part or all extra funds should be saved for the next down cycle.
- Sovereign wealth fund:
- Saves extra revenues (for example, from a boom in natural-resource prices).
- Should be invested in a diversified, highly liquid portfolio of assets, normally in international markets.
- Should be available for use based on objective criteria during economic crises.
- Independent fiscal institutions:
- Autonomous fiscal councils advise governments and legislatures on fiscal issues.
- Tasks include making technical recommendations, macro-fiscal projections, and assessments of fiscal sustainability.
- They should contribute to public debate and sound the alarm about fiscal risks from economic and political decisions.
Design principles and complementarities
- Fiscal rules can take many forms (limits on spending, public debt, or fiscal deficit), but some forms do not set a long-term vision and are less appropriate for commodity-exporting emerging market economies.
- Complementary use: such mechanisms can complement a cyclically adjusted revenue rule when an additional constraint is needed, especially for countries with high debt or rapidly accumulating liabilities.
- Fiscal rules must be:
- Flexible to deal with unexpected shocks.
- Equipped with a clear escape clause that contains a quantitative definition of failure to meet fiscal targets and describes mechanisms and deadlines for returning to a sustainable fiscal path.
- Fiscal rules should emphasize flexibility, simplicity, transparency, and achievement of a fiscal objective; complexity or noncompliance can undermine efficacy (as observed in several Latin American countries).
Evidence and post-pandemic priorities
- Joint analysis by Chile’s Ministry of Finance and the IMF (Larraín, Ricci, and Schmidt-Hebbel 2019) found increased adoption of fiscal rules by emerging market and developed economies.
- Findings stressed:
- Fiscal discipline is necessary because governments face an intertemporal budget constraint.
- Fiscal rules can contribute to fiscal sustainability, solvency, and economic performance.
- Growing empirical evidence indicates fiscal rules tend to improve fiscal performance, though effectiveness depends on design and compliance.
- Post-pandemic outlook:
- Once the pandemic is over, governments will carry more debt and sovereign funds will be smaller.
- In many cases fiscal adjustments will be necessary to ensure sustainability of fiscal accounts.
- Strengthening fiscal institutions should be an economic policy priority to ensure adjustments are organized, transparent, technically grounded, and minimize social impact.
Felipe Larraín Bascuñan, F&D Magazine, March 2022
Content in this bundle
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