Fiscal institutions are crucial for every country, but especially for those that are resource-intensive. And they become particularly important in pandemic times. Let us see why.
In individual countries’ responses to the COVID-19 pandemic, diversity in fiscal policy frameworks was a differentiating element. Richer countries or those that pursued responsible fiscal conduct in the years before the arrival of the virus were better able to strengthen health systems and deliver fiscal transfers, subsidies, and guarantees. This allowed faster recovery from the shock.
Aggressive fiscal responses to the pandemic had positive effects on stock markets, currencies, industrial production, employment, confidence, and sovereign risk premiums in the countries that implemented them (Deb and others 2021). There is also evidence that the effects were greater in advanced economies and in those with lower public debt. Most countries that had fiscal space or sovereign wealth funds were able to use these to deal with the economic and social effects of the pandemic.
In contrast, the poorest countries in Africa, the Americas, and Asia had limited leeway to respond, bolstering spending or forgoing revenue by less than 2.5 percent of GDP. Thus it will take years for them to recover from the economic and social effects of the pandemic, with significant negative impacts on output and income distribution.
The difference in many cases reflects the presence or absence of an institutional framework for fiscal policy. Chile, with the world’s 43rd largest economy and with a sound fiscal policy framework, was able to respond 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—increasing outlays or forgoing revenue by more than 10 percent of GDP.
How could this be? Quite simply, without an institutional framework for fiscal policy, government spending is bound by the amount of public resources available in a given year—reflecting mainly tax revenue—and a limited capacity to borrow. The problem with this mechanism is that fiscal revenues tend to be procyclical, and a spending policy financed with current revenues and constrained credit only exacerbates—rather than mitigating—the economic cycle. This generates pernicious macroeconomic effects on the volatility of key variables such as the exchange rate, inflation, and interest rates, with repercussions on investment, economic growth, and employment. It also puts at risk the long-term sustainability of financing required for more permanent policies such as public health, education, housing, and pensions.
This problem is even more pronounced for countries like Chile that are natural-resource-intensive, where commodity exports typically account for over 60 percent—and in some cases more than 90 percent—of total exports. In these cases, fiscal revenues depend not only on GDP but also on the prices of the goods the country produces and exports. In such economies it is even more important to establish an institutional framework to guide fiscal policy decisions.
Such a framework should be composed of at least three elements: a fiscal rule with a medium- to long-term perspective, sovereign wealth funds, and an independent fiscal institution such as an advisory fiscal council.
Beyond the sustainable financing of social policies, an institutional framework allows for a longer-term orientation for fiscal policy, which otherwise would be implemented with a time horizon in line with government terms. Thus, an appropriate fiscal framework highlights the existence of an intertemporal budget constraint that contemplates very long time horizons. This is crucial for responding to a shock such as the COVID-19 pandemic, both when resources need to be used and when it is necessary to carry out a fiscal consolidation to ensure the long-term sustainability of public finances.
It is essential that countries—especially emerging market and resource-intensive nations—have a fiscal framework with the three pillars.
Fiscal rule: A long-term vision that isolates public spending from the cyclical fluctuations of the economy must be set out. This can be achieved, for example, through 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 is higher than long-term levels because the country is experiencing a boom, part or all of the extra funds should be saved for the next down cycle, when tax revenues will inevitably fall.
