IMF Pamphlet Series - No. 49 -Guidelines for Fiscal Adjustment - How Should Fiscal Adjustment Be Effected?

Guidelines for Fiscal Adjustment

How Should Fiscal Adjustment Be Effected?

Undertaking fiscal adjustment often requires difficult decisions involving increasing government revenue and reducing spending.¹⁸ Expenditure reductions often tend to be stressed in the initial stages of adjustment, with particular emphasis on cuts in capital spending and current outlays on other goods and services (excluding wages, subsidies and transfers, and interest payments). Cuts in productive capital spending and essential operations and maintenance spending are liable to be damaging to growth. Consequently, countries need to move quickly on structural reforms affecting expenditure, revenue, and public enterprises in order to allow a more balanced approach to fiscal adjustment and to generate the resources necessary to support spending that addresses social and productive needs. As noted in Box 5, strengthening policy design and institutional capacity has been a major part of the Fiscal Affairs Department's technical assistance effort in recent years.

In designing fiscal adjustment strategies, policymakers often face short-term costs and constraints. Such concerns include the output and employment losses that may be incurred in rationalizing expenditure, the possible short-term negative effect on growth of raising taxes, and the difficulties in modifying implicit social contracts by altering the role of government. Experience with adjustment in many countries has, however, shown the high costs of delayed or disorderly adjustment. Inflation and overvalued exchange rates hit the poor hardest, as their incomes are often fixed in nominal terms or may depend on the production of tradable goods and services.

Attention to a proper mix and phasing of policy instruments is essential to minimize harm to the very poor and to provide social support for adjustment programs. Nevertheless, in many cases adverse effects still remain, and vulnerable groups need to be protected through well-targeted social safety nets. Some aspects of the design of social safety nets are discussed in Box 6.¹⁹

Box 5. Technical Assistance for Growth
Technical assistance by the IMF supports fiscal structural reform. The central objective is to assist member countries in the detailed design and implementation of fiscal policies needed for macroeconomic and structural adjustment and for sustainable growth. Considerable emphasis is placed on institution building. Technical assistance by the IMF's Fiscal Affairs Department (FAD) has traditionally focused on tax policy, tax and customs administration, and public expenditure management (budgeting, control of budget execution, reporting, and government accounting). More recently, FAD has expanded the scope of technical assistance to include Treasury and public debt management; expenditure policy, including the reform of social safety nets and social security; intergovernmental fiscal relations; and strengthening institutional capacity for fiscal analysis and fiscal management. Technical assistance on government finance statistics is provided by the IMF's Statistics Department.

Box 5. Technical Assistance for Growth

Technical assistance by the IMF supports fiscal structural reform. The central objective is to assist member countries in the detailed design and implementation of fiscal policies needed for macroeconomic and structural adjustment and for sustainable growth. Considerable emphasis is placed on institution building. Technical assistance by the IMF's Fiscal Affairs Department (FAD) has traditionally focused on tax policy, tax and customs administration, and public expenditure management (budgeting, control of budget execution, reporting, and government accounting). More recently, FAD has expanded the scope of technical assistance to include Treasury and public debt management; expenditure policy, including the reform of social safety nets and social security; intergovernmental fiscal relations; and strengthening institutional capacity for fiscal analysis and fiscal management. Technical assistance on government finance statistics is provided by the IMF's Statistics Department.

Box 6. Social Safety Nets
*Importance of Social Safety Nets (SSNs)* SSNs are a combination of measures aimed at mitigating the short-term adverse effects of economic reforms on the poor. Without SSNs, economic reform may, in the short term, lower the poor's living standards; it may also weaken the political sustainability of reform. Typical reforms with important consequences for the poor include reduction of generalized price subsidies on basic necessities; reform and restructuring of state enterprises and the civil service; and reduction of cash benefits. *Common Elements* Because SSNs need to work quickly and reliably, they have to be tailored to the specific circumstances of each country, including its administrative capabilities, the strength of its informal and formal social support systems, and the characteristics of the poor. Typically, the major components of SSNs have included the following: Targeted commodity subsidies and cash compensation. These schemes have sought to protect the consumption of basic food items by the poor in the face of rising prices, while reducing budgetary expenditure. Adaptation of permanent social security arrangements. The existing social security system, to the extent that it reaches significant portions of the poor, can be bolstered and its targeting and incentive/equity structure improved. The major schemes used are pension and disability insurances, and child allowances. Unemployment benefits, severance pay, and public works schemes. Because reforms usually involve a temporary increase in unemployment, an important aspect of SSNs has been enhanced unemployment benefit schemes, the provision of severance pay, and low-wage public works schemes. *Major Issues in Design* Targeting. To limit fiscal cost, social benefits should be limited to those most in need. Sophisticated means testing is generally not possible. Many countries rely on categorical targeting, such as limiting benefits to children or pensioners, or to households in certain regions. Commodity subsidies can be limited to goods consumed disproportionately by the poor or limiting the quantity that each household can consume, for example, via coupons. Incentives. The fiscal cost of the SSN is reduced the more sharply benefits are phased out with household income. This, however, is at the cost of increasing the implicit marginal tax rate facing beneficiaries, and thus the potential adverse impact on incentives.

Box 6. Social Safety Nets

Importance of Social Safety Nets (SSNs)

SSNs are a combination of measures aimed at mitigating the short-term adverse effects of economic reforms on the poor. Without SSNs, economic reform may, in the short term, lower the poor's living standards; it may also weaken the political sustainability of reform. Typical reforms with important consequences for the poor include reduction of generalized price subsidies on basic necessities; reform and restructuring of state enterprises and the civil service; and reduction of cash benefits.

Common Elements

Because SSNs need to work quickly and reliably, they have to be tailored to the specific circumstances of each country, including its administrative capabilities, the strength of its informal and formal social support systems, and the characteristics of the poor. Typically, the major components of SSNs have included the following:

Targeted commodity subsidies and cash compensation. These schemes have sought to protect the consumption of basic food items by the poor in the face of rising prices, while reducing budgetary expenditure.
Adaptation of permanent social security arrangements. The existing social security system, to the extent that it reaches significant portions of the poor, can be bolstered and its targeting and incentive/equity structure improved. The major schemes used are pension and disability insurances, and child allowances.
Unemployment benefits, severance pay, and public works schemes. Because reforms usually involve a temporary increase in unemployment, an important aspect of SSNs has been enhanced unemployment benefit schemes, the provision of severance pay, and low-wage public works schemes.

Major Issues in Design

Targeting. To limit fiscal cost, social benefits should be limited to those most in need. Sophisticated means testing is generally not possible. Many countries rely on categorical targeting, such as limiting benefits to children or pensioners, or to households in certain regions. Commodity subsidies can be limited to goods consumed disproportionately by the poor or limiting the quantity that each household can consume, for example, via coupons.
Incentives. The fiscal cost of the SSN is reduced the more sharply benefits are phased out with household income. This, however, is at the cost of increasing the implicit marginal tax rate facing beneficiaries, and thus the potential adverse impact on incentives.

Measures to Improve the Tax System and Increase Revenue

In some cases, revenue can be increased by raising rates within an existing system. However, the ability to generate increased revenue in this manner may be limited. This is particularly likely when an economy is undergoing substantial structural change, traditional tax bases are declining, and there are fundamental weaknesses in the tax system. Structural problems in the tax system may well be a major factor underlying not only fiscal deficits, but also poor growth and employment performance. Consequently, programs of fiscal adjustment are often accompanied by an effort to improve or even restructure the tax system.

This section focuses on questions relating to tax policy design during a reform period. It must be emphasized, however, that improvements in tax policy are more likely to be successful when they are accompanied by measures to strengthen tax administration. A brief overview of key issues in the administration area is provided in Box 7.

Box 7. Reforming Tax Administration
The essential elements required for successful tax administration reform include: an explicit and sustained political commitment; a team of capable officials dedicated to tax administration reform; a well-defined and appropriate reform strategy; relevant training for staff; additional resources for the tax administration or, at least, some reallocation of resources; and changes in incentives for both taxpayers and tax administrators. Tax administration reform must strive to enhance both its effectiveness and efficiency. Interventions to improve effectiveness include promotion of taxpayer self-assessment, provision of taxpayer education, adoption of procedures for minimizing the cost of compliance, implementation of systems for tax returns processing and accounting that quickly detect noncompliance and take appropriate actions, and establishment of an audit plan to detect violations as efficiently as possible. Also needed are adequate penalties for violations that strike at the heart of the tax system, such as failure to file returns and to pay taxes on time. Along with a strategy for enhancing effectiveness, tax administrations can adopt a number of measures to focus their scarce resources in the most efficient manner for revenue collection and enforcement. These measures include establishment of a large taxpayers' unit; adoption of a threshold for tax registration that exempts small enterprises from major taxes; the imposition of an alternative tax on small enterprises with limited revenue potential; use of final withholding of taxes on individual taxes; and use of banks for receiving tax payments. The above measures for improving the effectiveness and efficiency of tax administration suggest an organization of the tax administration to support five principal functions: taxpayer education; registration, accounting, and returns processing; collection enforcement; auditing; and legal services and appeals.

Box 7. Reforming Tax Administration

The essential elements required for successful tax administration reform include: an explicit and sustained political commitment; a team of capable officials dedicated to tax administration reform; a well-defined and appropriate reform strategy; relevant training for staff; additional resources for the tax administration or, at least, some reallocation of resources; and changes in incentives for both taxpayers and tax administrators.

Tax administration reform must strive to enhance both its effectiveness and efficiency. Interventions to improve effectiveness include promotion of taxpayer self-assessment, provision of taxpayer education, adoption of procedures for minimizing the cost of compliance, implementation of systems for tax returns processing and accounting that quickly detect noncompliance and take appropriate actions, and establishment of an audit plan to detect violations as efficiently as possible. Also needed are adequate penalties for violations that strike at the heart of the tax system, such as failure to file returns and to pay taxes on time.

Along with a strategy for enhancing effectiveness, tax administrations can adopt a number of measures to focus their scarce resources in the most efficient manner for revenue collection and enforcement. These measures include establishment of a large taxpayers' unit; adoption of a threshold for tax registration that exempts small enterprises from major taxes; the imposition of an alternative tax on small enterprises with limited revenue potential; use of final withholding of taxes on individual taxes; and use of banks for receiving tax payments.

The above measures for improving the effectiveness and efficiency of tax administration suggest an organization of the tax administration to support five principal functions: taxpayer education; registration, accounting, and returns processing; collection enforcement; auditing; and legal services and appeals.

Major reforms in tax design and administration take time to implement. New legislation is often required, and basic systems and procedures frequently need modification. In addition, reform may lead to changes in the relative tax burden of different groups and economic sectors. Short-term revenue requirements must also be addressed during the reform process. In developing short-term tax policy packages, particular consideration needs to be given to the revenue productivity of proposed measures, their administrative feasibility, and their likely consistency with the desired direction of more fundamental tax reform. On the basis of such criteria, the most promising short-term measures may emphasize increases in the rates of indirect taxes (particularly broad-based sales taxes and excises) and expansion of the tax base by eliminating exemptions.

Characteristics of a Desirable Tax System

The characteristics of a desirable tax system outlined below represent a blend of both macroeconomic and microeconomic considerations. In the former case, a tax system's responsiveness to GDP growth and its revenue-generating capacity are paramount. But since overall economic growth may be affected by the microeconomic allocative effects of a tax system and the post-tax distribution of income and wealth, the system's efficiency and transparency, for example, are also critical.

Revenue-generating capacity. A central objective of the tax system is to raise revenue to finance government spending, without resort to inflationary financing. This suggests the importance of a tax system that can generate revenue increases--at least in line with the growth in nominal income--without frequent changes in tax rates or introduction of new taxes. In this regard, reliance on specific (quantity-based) taxes in times of inflation, or on tax bases that are shrinking in relation to the rest of the economy, should be avoided because they contribute to low tax responsiveness (or elasticity).
Efficiency. Taxes influence relative prices in the economy and, therefore, have an impact on the pattern of production, consumption, and income. A desirable tax from the point of view of efficiency is one that minimizes its impact on relative prices, thus leaving the allocation of resources essentially undisturbed. Too heavy a tax on a particular commodity will tend to reduce its production and consumption and may, therefore, result in a loss of efficiency if scarce resources are diverted from their most productive use, in turn compromising growth. In practice, efficiency is achieved by levying taxes on as broad a tax base as possible and at fairly low and uniform rates. This also implies keeping tax exemptions to a minimum.
Equity. Taxes should be levied in a fair and equitable manner. The decision on what distribution of the tax burden is fair and equitable is something for each country to decide for itself, preferably through a democratic process. A distinction may be drawn between vertical and horizontal equity. The former refers to differentiation of the tax burden according to ability to pay (as measured by income, wealth, or consumption), while the latter refers to equal treatment of those in similar economic circumstances. Certain types of taxation may affect income distribution--for example, a progressive income tax or an excise on luxuries. However, expenditure policy is likely to be a more efficient instrument than taxation for influencing income distribution, through transfers and expenditures on social services, and targeted social assistance programs.
Transparency. Tax codes should be clearly drafted, well defined, and easily understood by the tax-paying community. For private investment, it is especially important to have tax rates that are both stable and predictable. Once tax laws are established that can generate buoyant revenue growth, it is preferable to minimize the frequency of discretionary modifications to these laws. If changes are planned over a reform period, taxpayers should ideally know in advance the tax implications of their production and consumption decisions. A simple, transparent tax system is also relatively easy to administer and promotes compliance.
Reasonable overall tax burden. There are constraints on how much a government can raise in taxes. Even if all the above criteria are met, too high a tax burden will undermine the system's effectiveness by encouraging tax evasion and distorting the structure of relative prices in the economy. One measure of the tax burden is the ratio of tax revenue to GDP, a ratio which varies widely among countries. An "acceptable" level of this ratio will be determined to some extent by public choices concerning the level of government expenditure or by other factors such as the need to service a large public debt.

Design of Major Taxes

Drawing on the above criteria, the following design features for major taxes are often recommended:

Sales tax/value-added tax (VAT). This should be a broadly based tax on final domestic consumption that does not tax intermediate consumption (thereby minimizing cumulative taxation as goods move through successive stages of production and distribution) or exports, and one that does not differentiate by source of production (foreign or domestic). Because of its efficiency and revenue security, the ideal instrument to achieve this objective is a VAT at a single rate, with crediting provisions and zero rating of exports.
Excises. A selected number of excises can be introduced to discourage consumption of particular items (for example, alcohol and tobacco); to link tax payments to the existence of negative externalities (for example, a gasoline tax as a means of pollution abatement); or to tax certain luxury goods. Excises should be levied equally on domestic production and imports and, particularly in an inflationary environment, on an ad valorem basis.
Customs duties. If a moderate level of protection is thought desirable to encourage local industry, a low uniform customs duty, when properly coordinated with a VAT and excises, is the preferred instrument. Duty drawback or suspension schemes are needed to relieve exporters of the anti-export bias caused by customs duties on inputs. To the extent such schemes are difficult to administer, particular importance attaches to maintaining a low tariff rate. Exemptions from customs duties should be limited and clearly defined to avoid abuse. A low across-the-board tariff may also be justified for revenue reasons in countries where other (and preferable) taxes may prove difficult to administer.
Export taxes. Export taxes should generally be avoided, since they tend to cause an outflow of resources in the export sector toward less efficient uses, thus compromising growth objectives. However, they can sometimes be used on a limited basis to reach hard-to-tax activities (common in the agriculture sector) as a temporary substitute for income taxation and to absorb one-time windfall gains, for example, from a devaluation or from exceptional movements in world commodity prices.
Profit Taxes. A tax on profits should ideally be levied at a single rate comparable to the top marginal rate of personal income tax. This minimizes the likelihood of tax-induced shifts between personal income, partnerships, and corporations. Deductions, allowances, and credits are best applied neutrally across sectors and assets to foster efficiency. Tax incentives (such as investment allowances and, particularly, tax holidays), if used at all, should be strictly limited in terms of coverage and duration. A minimum profits tax based on gross assets may be used in some circumstances to promote compliance and equity.
Income Taxes. A basic personal income exemption should be set high enough to exclude the very poor, and sufficient progressivity can be achieved with only a few income tax brackets. Tax brackets should be adjusted periodically in situations of high inflation to avoid the tendency for "bracket creep," and supply-side considerations argue for keeping rates as low as possible. Ideally, income taxes should be levied on a globalized income tax base (including all forms of income). However, it is often administratively necessary to establish schedular taxes on different sources of income. Final withholding taxes for wage (and possibly interest and dividend) income have proven successful in curtailing revenue leakage.

Rationalization of Expenditure Policies

Expenditure reduction measures have to be pragmatic, adequate to achieve the intended stabilization, but nonetheless economically, politically, and socially feasible. Several types of expenditure measures can be adapted quickly to contain a deteriorating fiscal situation. Sustainable expenditure reform, however, requires a review of underlying government policies, the composition of spending, the coverage of activities by the public sector, and the modes of delivery of public services. Quite often, a thorough structural reform of government expenditure policies can be done only in a medium-term framework.

Similar to the importance of tax administration in tax reform, efficient spending reduction usually requires improvements in systems of budget design, preparation, and execution. The broad direction of such reforms are reviewed in Box 8.

Box 8. The Budget and Expenditure Control
A government's ability to identify and execute expenditure cuts will depend on the quality of its budget--the primary instrument of expenditure management--and of its Treasury, which is responsible for the financial management of government operations. Budget design, preparation, and execution are all important elements of expenditure control. Design. The budget should be (i) comprehensive--hidden off-budget outlays reduce the effectiveness of budgetary policy; (ii) realistic--based on a solid macroframework; (iii) fully financed--based on expenditure policies that are genuinely consistent with reasonable revenue projections and financing provisions; and (iv) forward-looking--taking into account future costs, as well as immediate expenses. Preparation. The review of government priorities can often be strengthened through improvements in budget preparation. For instance, budget circulars may require (i) the strict costing of existing policies at existing standards of service; (ii) that no new policy be introduced without identifying offsetting savings and fully evaluating the full year's cost of the policy change for later years; and (iii) that each ministry identify how it would spend any additional specified percentage increase or decrease in its present ceiling. Execution. A flexible and responsive execution of the budget is necessary if fiscal policy is to be an effective demand management tool. Needed inputs include (i) a timely and comprehensive monitoring system, which provides early warnings about expenditure pressures, and revenue and financing shortfalls; (ii) an effective cash management system to contain gaps between resources and spending requests; and (iii) a broader financial management function, which projects fiscal needs and coordinates government operations with monetary and balance of payments policies. The organizational structure of these functions differs widely from country to country; however, experience suggests that a strong Treasury can play a decisive role in effective budget management. The important functions of the Treasury include (i) cash management--the control of all flows to and from government accounts, either directly or through banks; (ii) financial planning--the projection of inflows and resource requirements; (iii) public debt management; and (iv) the control of government financial assets.

Box 8. The Budget and Expenditure Control

A government's ability to identify and execute expenditure cuts will depend on the quality of its budget--the primary instrument of expenditure management--and of its Treasury, which is responsible for the financial management of government operations. Budget design, preparation, and execution are all important elements of expenditure control.

Design. The budget should be (i) comprehensive--hidden off-budget outlays reduce the effectiveness of budgetary policy; (ii) realistic--based on a solid macroframework; (iii) fully financed--based on expenditure policies that are genuinely consistent with reasonable revenue projections and financing provisions; and (iv) forward-looking--taking into account future costs, as well as immediate expenses.
Preparation. The review of government priorities can often be strengthened through improvements in budget preparation. For instance, budget circulars may require (i) the strict costing of existing policies at existing standards of service; (ii) that no new policy be introduced without identifying offsetting savings and fully evaluating the full year's cost of the policy change for later years; and (iii) that each ministry identify how it would spend any additional specified percentage increase or decrease in its present ceiling.
Execution. A flexible and responsive execution of the budget is necessary if fiscal policy is to be an effective demand management tool. Needed inputs include (i) a timely and comprehensive monitoring system, which provides early warnings about expenditure pressures, and revenue and financing shortfalls; (ii) an effective cash management system to contain gaps between resources and spending requests; and (iii) a broader financial management function, which projects fiscal needs and coordinates government operations with monetary and balance of payments policies. The organizational structure of these functions differs widely from country to country; however, experience suggests that a strong Treasury can play a decisive role in effective budget management.

The important functions of the Treasury include (i) cash management--the control of all flows to and from government accounts, either directly or through banks; (ii) financial planning--the projection of inflows and resource requirements; (iii) public debt management; and (iv) the control of government financial assets.

Expenditure Reduction in the Short Run

There are no hard and fast rules about how public expenditure should be cut. This will depend partly on the factors driving the growth in spending (for example, wages and salaries or the capital program), as well as on the social and political constraints facing policymakers. However, experience suggests some guidelines.

Avoid across-the-board cuts. Across-the-board cuts often seem attractive; this approach allows each individual operating ministry to decide how to cut its budget--whether to delay the purchase of goods and services, run down stocks, cut back on temporary staff, etc.;²⁰ and it appears to imply equal hardship for all and is thus seen as equitable. But there is little rationale for assuming that cuts in dissimilar programs (such as education and defense) will have the same economic consequences. An across-the-board approach also has other disadvantages: it can quickly lead to the accumulation of payment arrears; it may add to long-term costs--for instance by postponing maintenance; it avoids the responsibility of looking at priorities; and it can lead to inefficiencies by disturbing work patterns (for example, no gasoline for tax inspection vehicles or ambulances). Last, it defers a more in-depth restructuring that preserves an efficient ratio between personnel, operations, and capital outlays. In the absence of such restructuring, any savings are usually quickly reversed.
Identify specific program reductions. Programs often can and should be dropped, pruned, or consolidated, as economies develop and government priorities change. For instance, free milk distribution may become unnecessary when income levels rise above a certain level. Effective price liberalization can eliminate the need for subsidies. The end of the "cold war" has permitted many military bases to be closed, with associated cutbacks in weapons development. Program elimination usually leads to effective savings, because it requires governments to redefine their priorities and is, therefore, a first step toward the more fundamental expenditure review discussed below. Moreover, program elimination tends to preserve the efficiency of operations elsewhere in the public sector.
Cut the public sector wage bill. Wage restraint in the public sector can be a major source of savings. There is, however, a limit on how far wage standstills, freezes, etc., can be made to operate effectively. Any prolonged disparity between public and private sector wages may result in a loss of high-quality staff, as well as increased risks of moonlighting and corruption. Cutbacks in civil service numbers are often a more appropriate reform, especially since many countries have in the past overexpanded their public services to absorb a growing labor force.
Ceilings on total employment or the specification of downward targets for the wage bill can be enforced through measures such as hiring bans, the elimination of vacant positions, a freeze on staff complements, the cessation of automatic hiring practices (for example, of university graduates), voluntary and early retirement programs, and reorganization. However, with time, managers can often circumvent such controls. Thus, while such measures can be effective in the short-term, they should be seen as interim substitutes for a deeper review of personnel policies and program staffing needs.
Target social programs narrowly. Transfers can be made more efficient by targeting eligibility and by reducing income replacement rates. Income redistribution programs cannot be used to raise average incomes--rather they seek to ensure that the incomes of targeted individuals do not fall below a minimum income. Means testing is the ideal method of targeting, but is often not possible in countries with limited administrative capacity and a high share of nonwage income. Instead, targeting may be improved by concentrating transfers on identified vulnerable groups (such as pensioners living alone, disabled veterans, or single mothers). Where possible, multiple programs for social protection should be consolidated into more global schemes of income transfers, because there can be significant overlap in entitlements provided by uncoordinated agencies. To the extent possible, price subsidies should be replaced by targeted income transfers, since access to subsidized goods can rarely be confined.
Review the capital program. The capital program has often been a prime target for short-term retrenchment. Postponement of projects not yet begun can save resources with relatively little disruption of day-to-day government operations. However, if a program has an important infrastructure component, its deferral may lead to a lower growth rate and consequent future fiscal costs. Moreover, if capital expenditure is cut by eliminating or slowing down projects already under way, there may be a substantial loss of sunk costs. Hence, capital programs are best cut in the context of an overall public investment review--often possible only as part of a medium-term strategy.
Raise fees and charges. Governments are often reluctant to take actions that will reduce volumes or standards of delivery in high-priority areas like education and health. Hence, savings in these areas may best be achieved by raising cost recovery through an increase in the fees and charges for services. Since the government is a full or near monopoly supplier of many services, it has substantial scope for raising fees and charges, subject to social and political considerations. In general, where the government provides services, its broad objective should be to cover costs: activities that generate profit could probably be privatized (and, if necessary, regulated); and, conversely, any subsidy element built into the charges to protect poorer groups could better be provided transparently by targeted income support.
Seek least-cost debt service. The interest bill is often the most inflexible component of expenditure. Moreover, when it is large, shocks to the terms of debt service can seriously destabilize the budget. Experience suggests several rules of thumb. Where possible, governments should avoid indexing domestic debt service either to the price level or to a foreign currency. Appropriate compensation should rather be provided by a market-based domestic interest rate and credibility established by a prudent fiscal stance. The currency composition of foreign borrowing should, to the extent feasible, correspond to the composition of export and other external receipts in order to minimize exchange risks. More generally, governments should aim to borrow abroad in currencies that do not fluctuate widely vis-à-vis the domestic currency, and should actively monitor and manage their portfolios to avoid incurring higher-than-market interest or exchange costs. Finally, governments should try to avoid guaranteeing nongovernment borrowing, since it creates incentives for default; when access to necessary foreign borrowing would be impossible in the absence of a government guarantee, the criteria for granting guarantees should be transparent and based on an objective assessment of the recipient's ability to repay.
Reform public enterprises. Public enterprises should, in general, not be a drain on the budget. If they are in deficit, pricing structures should be adjusted, the scope of activities redefined, their employment policy reassessed, and their capital program rationalized. Preferably, they should be privatized and fully exposed to a competitive market environment.

Structural Public Expenditure Reform

Fundamental structural reform requires consideration of basic questions on the need for different government activities, the appropriateness of their provision in the public sector, the importance of their provision by public institutions (as opposed to contracting out), and the possibility of introducing a market framework for their provision, even when public institutions are responsible for delivery. For activities selected to remain in the public sector, specific objectives need to be set, desired outputs quantified (where possible), inputs determined, and managerial freedom given to pursue the most efficient delivery of services.

The tools for expenditure rationalization are long established, but growing in sophistication--particularly in a relatively small number of OECD countries. They include program- and zero-based budgeting, "value-for- money" audits, fundamental reviews, etc., which are being increasingly used to require ministries to demonstrate the need for individual programs and to evaluate the efficiency of service delivery.

Certain requirements are key: the assessment should start from a zero base--questions must be posed about why an activity is being undertaken, rather than just about the standards and efficiency of the current service; the evaluation must be patently objective, which requires either an external review, for instance by value-for-money auditors, or a review by central (independent) ministry officials; and it should likewise be comprehensive so that no ministry escapes review over time. Finally, the government's long-term commitment to a reform and review process needs to be clear.

A comprehensive review might generate the following types of reforms:

The elimination of unproductive or very low-priority services.
Privatization of activities that can, and should, be carried out in the private sector.
The introduction of a more commercial approach to public activities, including: competitive tendering, the contracting out of some services to the private sector, and the use of commercial accounting techniques to set the basis for full cost recovery.
The wider use of improved accounting techniques, not just by presenting accounts on a commercial basis where appropriate, but also by using balance sheets to improve the analysis of the long-term implications of existing and new expenditures.
The simulation of market discipline, including separate assessment of its application to the government's role as purchaser and provider of services (for example, in health care).
For those services that are to remain in the public sector, measures designed to improve managerial performance, efficiency, and effectiveness, including establishing cost centers--which combine under a unified management the costing of interlinked activities; setting objectives, output requirements, and inputs for each center; more devolved managerial authority for the centers; and the linking of managers' salaries to performance.

¹⁸ Comparable decisions have to be made by countries undertaking fiscal stimulus. Factors influencing the choice of measures should include, inter alia: the effects of different tax and spending measures on private sector demand (for example, tax cuts are liable to have greater impact on modifying the expenditure decisions of households if they are viewed as permanent); the productivity of proposed increases in government spending; and the likely difficulty of reversing the stimulus measures in the event of the need for future fiscal consolidation.
¹⁹ The more general issues of the impact of fiscal and other adjustment policies on income distribution were presented at a conference on "Income Distribution and Growth," held at the IMF, Washington, June 12, 1995.
²⁰ Squeezing of cash limits is an extreme variant of an across-the-board approach. It is often applied by deliberate underprovisioning for inflation in setting annual budget ceilings.

< PREVIOUS

PAMPHLET NO. 49 CONTENTS

NEXT >