Guidelines for Fiscal Adjustment

How Much Fiscal Adjustment Is Required?

Fiscal adjustment policies should be designed within an overall methodological framework that links the implementation of a comprehensive set of policy measures to the achievement of the economy's objectives for inflation, growth, and external balance. Policy-setting within this framework requires decisions about the appropriate amount and form of fiscal adjustment, including the desired level of the fiscal deficit. A key link between the deficit and macroeconomic goals is through its financing. The use of bank credit, as well as nonbank domestic and foreign borrowing, to finance the government's operations must take account of the impact of each financing option on aggregate demand and prices, interest rates, the exchange rate, and the external balance.

A fiscal adjustment strategy may, in principle, require either a more restrictive or expansionary fiscal policy stance. Large structural deficits, rising government debt, and the need to address domestic and external constraints have emphasized the crucial importance of fiscal consolidation in many countries. The subsequent discussion largely focuses on such cases. However, there are also countries where domestic demand is weak and the underlying fiscal and external situation sufficiently strong, where fiscal stimulus may be appropriate.

This section considers the overall framework within which fiscal policies are formulated and some criteria for determining the amount of fiscal adjustment within this framework. Specific tax and expenditure strategies to achieve the required fiscal adjustment are reviewed in the following section on how fiscal adjustment should be effected.

A Framework for Fiscal Adjustment

For adjustment programs that qualify for financial support from the IMF, the methodological framework within which fiscal policies are designed is sometimes referred to as "financial programming." An essentially similar framework is used by policymakers for domestic policy formulation. Some key elements of a financial program are as follows:

Determining the Amount of Fiscal Adjustment

The amount of fiscal adjustment needed is usually discussed in relation to the desired reduction in the overall fiscal deficit; often, possible trade-offs are suggested between the quantity and quality of adjustment measures.

Reducing the Fiscal Deficit

In general, when macroeconomic imbalances are pronounced, the need for fiscal adjustment is not in question. The desired amount of deficit reduction must be assessed in the context of overall macroeconomic policies and constraints. An issue that usually arises is the amount of reduction that is needed and the possible time period over which such adjustment can be achieved. Some more general factors affecting the required amount of deficit reduction are indicated below.17 In some circumstances, it may even be appropriate for a country to run a fiscal surplus (see Box 4).

Box 4. When Should a Country Run a Fiscal Surplus?
There are certain circumstances when the appropriate balance for a country is likely to be a surplus.

  • To finance productive expenditure. When governments provide "lumpy" goods, for example, large investment projects, it makes sense to finance them through borrowing rather than by raising tax rates. This borrowing can then be repaid from a fiscal surplus when public spending is low. If the private sector has the capacity, but not the funds, to provide certain productive goods, the government can step in by on-lending funds it has borrowed, which, when repaid, may lead to a surplus; the government may also choose to run a surplus in order to increase savings available to the private sector through the capital market.

  • To stabilize the economy. To reduce inflation and/or the current account deficit, fiscal contraction is usually necessary and may imply a surplus. To dampen business cycles, governments can smooth aggregate demand over the cycle, which may imply a surplus during a boom. A negative supply shock (such as a drought), a positive demand shock (such as a property boom), or large capital inflows also justify a fiscal contraction, which may imply a surplus.

  • To sustain the debt. If government debt is unsustainable, a primary fiscal surplus will, in general, be necessary, and the debt problem may be so severe as to require an overall surplus. Indeed, a surplus itself may increase the sustainability of government policies by sending a highly visible signal to economic agents of the government's prudence.

  • To build up wealth. When certain proceeds, such as mineral income, foreign grants, or privatization receipts, are exceptionally high, governments should save a portion for future use. To the extent that these receipts are classified as revenue, this may imply a surplus. Similarly, with an aging population, a PAYG (pay-as-you-go) pension scheme should run a surplus, which, if consolidated into the budget, may imply a fiscal surplus.

Quality of Adjustment

The required amount of fiscal adjustment is not independent of the quality of the specific measures chosen for its implementation. An assessment of quality would focus on the sustainability and the durability of the measures being considered and on the relative impact of alternative policy options on investment and production incentives as well as on the external account.

Specifically, short-term reduction of deficits through measures that cannot be sustained, or which may have adverse effects on growth over the medium term, should be viewed critically. Temporary surtaxes, tax amnesties, sales of public assets, and other measures may allow a country to stay within an agreed ceiling, but without doing anything to reduce its underlying deficit. Similarly, the postponement of essential operations and maintenance spending or inevitable wage increases, and even the deferral of payments, will be only of temporary value and may do more harm than good over the medium term. This argues for measures that are likely to be durable over the longer term, which do not diminish the efficiency of public sector operations and are the least costly in terms of their effects on growth in the rest of the economy.

Indeed, particular fiscal instruments may, over time, induce an important enough supply response in the economy to reduce the magnitude by which the deficit needs to be shrunk. For example, elimination of an export tax may, over the medium term, generate an expansion in output and export earnings, which increases revenue from other tax sources. Similarly, a policy to reduce employment in the public sector, especially in unprofitable public enterprises, may contribute to increased efficiency and lower costs in the medium term even though in the short-run fiscal deficits may increase due to the need for outlays on separation and unemployment benefits. Consequently, such measures need to be implemented as part of an overall policy package that provides for an appropriate degree of reduction of government absorption in the short run.

17 Analogous factors will affect the required amount of fiscal stimulus in countries where an increase in the deficit (or reduction in the surplus) is in order. However, in this case the emphasis is likely to be on the strength of the underlying fiscal and public debt position, the needed stimulus in domestic demand, and the desired adjustment in the external current account surplus.